20-F 1 k01104e20vf.htm CANON INC. CANON INC.
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________
FORM 20-F
     
o
  REGISTRATION STATEMENT PURSUANT TO SECTION 12(b)
OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
 
  OR
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
 
  OR
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
  For the transition period from ____________ to ____________
 
  OR
o
  SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
  Date of event requiring this shell company report                     
     
   
Commission file number 001-15122
 
 
CANON KABUSHIKI KAISHA
(Name of Registrant in Japanese as specified in its charter)
CANON INC.
(Name of Registrant in English as specified in its charter)
JAPAN
(Jurisdiction of incorporation or organization)
30-2, Shimomaruko 3-chome, Ohta-ku, Tokyo 146-8501, Japan
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the Act.
     
Title of each class   Name of each exchange on which registered
(1) Common Stock (the “shares”)
  New York Stock Exchange*
(2) American Depositary Shares (“ADSs”), each of which represents one share
  New York Stock Exchange
Securities registered or to be registered pursuant to Section 12(g) of the Act.
None
(Title of Class)
_________________________
Securities for which there is a reporting obligation pursuant
to Section 15(d) of the Act.
None
(Title of Class)
* Not for trading, but only for technical purposes in connection with the registration of ADSs.
Indicate the number of outstanding shares of each of the issuer’s classes
of capital or common stock as of the close of the period covered by the
annual report.
As of December 31, 2005, 888,742,779 shares of common stock, including 49,384,651
ADSs, were outstanding.

 


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     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ No o
     If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes  þ          No  o
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark which financial statement item the registrant has
elected to follow.
Item 17  þ          Item 18  o
     If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
 
 

 


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TABLE OF CONTENTS
             
        Page number
CERTAIN DEFINED TERMS, CONVENTIONS AND PRESENTATION OF FINANCIAL INFORMATION     1  
   
 
       
FORWARD-LOOKING INFORMATION     1  
   
 
       
PART I
   
 
       
Item 1.    Identity of Directors, Senior Management and Advisers     2  
   
 
       
Item 2.    Offer Statistics and Expected Timetable     2  
   
 
       
Item 3.    Key Information     2  
   
 
       
      2  
      3  
      3  
      3  
   
 
       
Item 4.    Information on the Company     9  
   
 
       
      9  
      10  
        10  
        13  
        13  
        14  
        15  
        15  
        15  
        16  
        17  
      19  
      20  
   
 
       
Item 5.    Operating and Financial Review and Prospects     23  
   
 
       
      23  
        23  
        24  
        26  
        26  
        29  
        34  
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      35  
      36  
        36  
        37  
      38  
      38  
   
 
       
Item 6.    Directors, Senior Management and Employees     39  
   
 
       
      39  
      43  
      44  
      44  
      45  
   
 
       
Item 7.    Major Shareholders and Related Party Transactions     46  
   
 
       
      46  
      46  
      46  

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        Page number
Item 8.    Financial Information     47  
   
 
       
      47  
        47  
        47  
        47  
      48  
   
 
       
Item 9.    The Offer and Listing     48  
   
 
       
      48  
        48  
        49  
      49  
      49  
   
 
       
Item 10.  Additional Information     50  
   
 
       
      50  
      50  
      54  
      54  
      55  
      57  
      57  
      57  
      57  
   
 
       
Item 11.  Quantitative and Qualitative Disclosures About Market Risk     57  
   
 
       
 
  Market risk exposures     57  
        58  
        58  
   
 
       
Item 12.  Description of Securities Other than Equity Securities     59  
   
 
       
PART II
   
 
       
Item 13.  Defaults, Dividend Arrearages and Delinquencies     60  
   
 
       
Item 14.  Material Modifications to the Rights of Security Holders and Use of Proceeds     60  
   
 
       
Item 15.  Controls and Procedures     61  
   
 
       
Item 16A.  Audit Committee Financial Expert     61  
   
 
       
Item 16B.  Code of Ethics     61  
   
 
       
Item 16C.  Principal Accountant Fees and Services     61  
   
 
       
Item 16D.  Exemptions from the Listing Standards for Audit Committees     62  
   
 
       
Item 16E.  Purchases of Equity Securities by the Issuer and Affiliated Purchasers     63  
   
 
       
PART III
   
 
       
Item 17.  Financial Statements     64  
   
 
       
 
  Reports of Independent Registered Public Accounting Firms     65  
        67  
        68  
        69  
        70  
        71  
        114  
   
 
       
Item 18.  Financial Statements     115  
   
 
       
Item 19.  Financial Statements and Exhibits     115  
   
 
       
SIGNATURES     116  
   
 
       
EXHIBIT INDEX     117  
 EX-1.1 ARTICLES OF INCORPORATION OF CANON INC.(TRANSLATION)
 EX-12 302 CERTIFICATIONS
 EX-13 906 CERTIFICATION

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CERTAIN DEFINED TERMS, CONVENTIONS AND PRESENTATION OF FINANCIAL INFORMATION
All information contained in this Annual Report is as of December 31, 2005 unless otherwise specified.
References in this discussion to the “Company” are to Canon Inc. and, unless otherwise indicated, references to the financial condition or operating results of “Canon” refer to Canon Inc. and its consolidated subsidiaries.
On March 31, 2006, the noon buying rate for yen in New York City as reported by the Federal Reserve Bank of New York was Yen117.48= U.S.$1.
The Company’s fiscal year end is December 31. In this Annual Report “fiscal 2005” refers to the Company’s fiscal year ended December 31, 2005, and other fiscal years of the Company are referred to in a corresponding manner.
FORWARD-LOOKING INFORMATION
This Annual Report contains forward-looking statements and information relating to Canon that are based on beliefs of its management as well as assumptions made by and information currently available to Canon Inc. When used in this Annual Report, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “project” and “should” and similar expressions, as they relate to Canon or its management, are intended to identify forward-looking statements. Such statements reflect the current views and assumptions of the Company with respect to future events and are subject to risks and uncertainties. Many factors could cause the actual results, performance or achievements of Canon to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements, including, among others, changes in general economic and business conditions, changes in currency exchange rates and interest rates, introduction of competing products by other companies, lack of acceptance of new products or services by Canon’s targeted customers, inability to meet efficiency and cost reduction objectives, changes in business strategy and various other factors, both referenced and not referenced in this Annual Report. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended, planned or projected. Canon Inc. does not intend or assume any obligation to update these forward-looking statements.

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PART I
Item 1.   Identity of Directors, Senior Management and Advisers
     Not applicable.
Item 2.   Offer Statistics and Expected Timetable
     Not applicable.
Item 3.   Key Information
   A.   Selected financial data
     The following selected consolidated financial data has been derived from the consolidated financial statements of Canon as of each of the dates and for each of the periods indicated below. This information should be read in conjunction with and qualified in its entirety by reference to the Consolidated Financial Statements of Canon Inc. and subsidiaries, including the notes thereto, included in this Annual Report. These financial statements have been audited by Ernst & Young ShinNihon, Independent Registered Public Accounting Firm as of and for the year ended December 31, 2005 and 2004. The financial statements for periods prior to the year ended December 31, 2004 were audited by KPMG AZSA & Co., Independent Registered Public Accounting Firm.
                                         
Selected financial data *1:   2005     2004     2003     2002     2001  
    (Millions of yen except average number of shares and per share data)  
 
Net sales
  ¥ 3,754,191     ¥ 3,467,853     ¥ 3,198,072     ¥ 2,940,128     ¥ 2,907,573  
Operating profit
    583,043       543,793       454,424       346,359       281,839  
Income before cumulative effect of change in accounting principle
    384,096       343,344       275,730       190,737       163,869  
Net income
    384,096       343,344       275,730       190,737       167,561  
Advertising expenses
    106,250       111,770       100,278       71,725       66,837  
Research and development expenses
    286,476       275,300       259,140       233,669       218,616  
Depreciation of property, plant and equipment
    205,727       174,397       168,636       158,469       147,286  
Capital expenditures
    383,784       318,730       210,038       198,702       207,674  
Long-term debt, excluding current installments
    27,082       28,651       59,260       81,349       95,526  
Common stock
    174,438       173,864       168,892       167,242       165,287  
Stockholders’ equity
    2,604,682       2,209,896       1,865,545       1,591,950       1,458,476  
Total assets
    4,043,553       3,587,021       3,182,148       2,942,706       2,844,756  
 
                                       
Average number of common shares in thousands
    887,174       885,365       878,649       876,716       875,960  
 
                                       
Per share data:
                                       
Income before cumulative effect of change in accounting principle:
                                       
Basic
  ¥ 432.94     ¥ 387.80     ¥ 313.81     ¥ 217.56     ¥ 187.07  
Diluted
    432.55       386.78       310.75       214.80       184.55  
Net income:
                                       
Basic
  ¥ 432.94     ¥ 387.80     ¥ 313.81     ¥ 217.56     ¥ 191.29  
Diluted
    432.55       386.78       310.75       214.80       188.70  
Cash dividends declared
    100.00       65.00       50.00       30.00       25.00  
Cash dividends declared (U.S.$)*2
  $ 0.870     $ 0.601     $ 0.464     $ 0.254     $ 0.196  
Notes:
  1.   The above financial data are prepared in accordance with U.S. generally accepted accounting principles.
  2.   Annual cash dividends declared (U.S.$) translated from yen based on a weighted average of the noon buying rates for yen in New York city as reported by the Federal Reserve Bank of New York in effect on the date of each semiannual dividend payment.

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     The following table provides the noon buying rates for Japanese yen in New York City as reported by the Federal Reserve Bank of New York expressed in Japanese yen per U.S.$1 during the periods indicated and the high and low noon buying rates for Japanese yen per U.S.$1 during the months indicated.
                                   
Yen exchange rates per U.S. dollar:   Average     Term end     High     Low  
2001     122.18       131.04       114.26       131.47  
2002     124.81       118.75       115.71       134.77  
2003     115.83       107.13       106.93       121.42  
2004     107.63       102.68       102.56       114.30  
2005
- Year
    110.74       117.88       120.93       102.26  
 
- 1(st) half
            110.91       110.91       102.26  
 
- July
            112.25       113.42       110.47  
 
- August
            110.84       112.12       109.37  
 
- September
            113.29       113.32       109.66  
 
- October
            116.36       116.36       113.54  
 
- November
            119.66       119.66       116.63  
 
- December
            117.88       120.93       115.78  
2006
- January
            116.88       117.55       113.96  
 
- February
            115.82       118.95       115.82  
 
- March
            117.48       119.07       115.89  
     B.   Capitalization and indebtedness
                 Not applicable.
     C.   Reasons for the offer and use of proceeds
                 Not applicable.
     D.   Risk Factors
     Canon is one of the world’s leading manufacturers of plain paper copying machines, digital multifunction devices, laser beam printers, bubble jet printers, cameras, steppers and aligners.
     Primarily because of the nature of the business areas and geographical areas in which Canon operates and the highly competitive nature of the industries to which it belongs, Canon is exposed to a variety of risks and uncertainties in carrying out its businesses, including, but not limited to, the following:
Risks Related to Canon’s Industries
     Canon has invested and will continue to invest heavily in next-generation technologies. If the market for these technologies does not develop as Canon expects or if its competitors produce these or competing technologies in a more timely or effective manner, Canon’s operating results could be materially adversely affected.
     Canon has made and will continue to make investments in next-generation technology research and development initiatives. Canon’s competitors may achieve research and development breakthroughs in these technologies more quickly than Canon, or may achieve advances in competing technologies that render products under development by Canon uncompetitive. In step with the continuous evolution in technologies, Canon has increased the size of its investment in development and manufacturing. If Canon’s business strategies diverge from market needs, Canon may not recover some or all of its investment, lose business opportunities, or both, which may materially adversely affect Canon’s operating results. While differentiation in technology and product development is an important part of Canon’s strategy, Canon must also accurately assess the demand for and perceived market acceptance of new technologies and products that it develops. If Canon pursues technologies or develops products that do not become commercially accepted, its operating results could be adversely affected.
     It is assumed that Canon will enter into the new business field by having next-generation technology as Canon’s corporate strategy. However, even if Canon enters into new field of business, there are risks that Canon may not establish a business model or may get involved in competition with new competitors. If such risks arise, Canon’s operating results will be adversely affected.
     If Canon does not effectively manage transitions in its products and services, its operating results may decline.
     Many of the businesses in which Canon competes are characterized by rapid technological advances in hardware performance, software functionality and product features, the frequent introduction of new products, short product life cycles, and continual improvement in product price characteristics relative to product performance. If Canon does not make an effective transition from existing products and services to new offerings, its revenue and profits may decline. Among the risks associated with the introduction of new products and services are delays in development or manufacturing, low product marketability due to poor product quality, variations in manufacturing costs, delays in customer purchases in anticipation of new introductions, difficulty in predicting customer demand for new product offerings and difficulty in effective management of inventory levels in line with anticipated demand. Canon’s revenue and gross margin also may suffer due to the timing of product or service introductions by its competitors. This risk is exacerbated when a product has a short life cycle or a competitor introduces a new product just before Canon’s introduction of a similar product. Furthermore, sales of Canon’s new products and services may replace sales of, or result in discounting of, some of its current product offerings, sometimes offsetting the benefits derived from the introduction of a successful new product or service. Canon must also ensure that its new products are not duplicative or do not overlap with existing products and operations. Given the competitive nature of Canon’s businesses, if any of these risks materialize, future demand for its products and services will be reduced and its results of operations may decline.

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     Canon’s businesses, especially the digital multifunction device and camera businesses in which Canon operates, is highly competitive.
     The recent trend of rapid digitalization has resulted in the entry of new competitors, such as electronics manufacturers and other specialized companies which were not active during the analog camera era. If the digital camera industry develops more rapidly than at the pace that Canon anticipates, Canon may not be able to maintain its position as an industry leader in many of its business categories. Although Canon believes that it has successfully kept pace with this trend toward digitalization, its survival in this increasingly competitive environment will depend on our investments in research and development, ability to cut costs and commitment to continuously providing the market with attractive products offering high added-value.
     In addition, the unexpected emergence of strong competitors through mergers and acquisitions or the formation of business alliances may change the competitive environment of the businesses in which Canon engages, thereby affecting Canon’s future results of operations.
     Because the semiconductor industry is highly cyclical, Canon may be adversely affected by any downturn in the industry.
     The semiconductor industry is characterized by up and down business cycles, the timing, length and volatility of which are difficult to predict. Recurring periods of oversupply of integrated circuits have at times led to significantly reduced demand for capital equipment, including the steppers and aligners Canon produces. Despite this cyclicality, Canon must maintain significant levels of research and development expenditures in order to maintain its competitive position. Canon’s business and operating results could be materially adversely affected by future downturns in the semiconductor industry and related fluctuations in the demand for capital equipment in general, and particularly by memory manufacturers.
     In addition, liquid crystal display ( “LCD”) panel manufacturers are facing severe price-reduction of LCD panels as a result of intense competition of LCD televisions and LCD monitors used in PCs. As a result, panel manufacturers may reduce equipment investment, which may adversely affect Canon’s business operations.
     Downturns in the semiconductor industry have caused Canon’s customers to change their operational strategies, which in turn may affect Canon’s business.
     Many device manufacturers have changed their business models to focus on the design of semiconductors, while consigning the production of semiconductors to lower-cost foundries. Canon cannot accurately predict the future effect of these trends on its business. However, as research and development, manufacturing and sales activities become increasingly globalized in response to these trends, shifting particularly to emerging markets, unexpected global developments, such as adverse regulatory or legal changes and unanticipated events, such as natural disasters, may adversely affect Canon’s business operations.
     In addition, there are only approximately ten companies in the world which produces large-sized LCD panels in the world. If Canon cannot keep up with the market trend of LCD panel industries, including market reorganization, Canon may not be able to maintain its customer which may materially adversely affect Canon’s business operations.
     The semiconductor equipment industry is characterized by rapid technological change. If Canon does not constantly develop new products to keep pace with technological change and meet its customers requirements, Canon may lose customers and its business may suffer.
     Canon’s steppers and mask aligners are affected by rapid technological change and can quickly become obsolete. Canon believes its future success in the steppers and aligners business depends on its ability to continue to enhance its existing products and develop new products using new and more advanced technologies. In particular, as semiconductor pattern sizes continue to decrease, the demand for more technologically advanced steppers is likely to increase. Although Canon will continue to offer cost effective products by managing manufacturing costs through its technology, Canon’s existing stepper and mask aligner products could become obsolete sooner than anticipated because of faster than anticipated changes in one or more of the technologies related to Canon’s products or in the market demand for products based on a particular technology. Any failure by Canon to develop the advanced technologies required by its customers at progressively lower costs and to supply sufficient quantities to a worldwide customer base could adversely affect Canon’s net sales and profitability.
     Growing diversification in recording media may adversely affect Canon’s video camcorder business.
     As part of the overall digitization of the consumer electronics market, the video camera market is successfully moving toward digitalization. At the same time, in the market that was once dominated by MiniDV standard, new digital standards, such as DVD (Digital Versatile Drive), HDD (Hard Disk Drive), SD (Secure Digital) memory card and high-resolution recording format such as HDV, have appeared. If these competing standards gain wide acceptance in the market, sales of Canon’s products using mainly the MiniDV standard may decline.
     In addition, Canon may be required to incur significant research and development expenditures to develop new products that are compatible with such new standards. Such trends may have an adverse affect on Canon’s video camcorder business as well as its operating results.
Risks Related to Canon’s Business
     Canon derives a significant percentage of its revenues from Hewlett-Packard.
     Canon depends on Hewlett-Packard for a significant part of its business. For fiscal 2005, approximately 21% of Canon’s net sales were to Hewlett-Packard. As a result, its business and results of operations may be affected by the policies, business and results of operations of Hewlett-Packard. Any decision by Hewlett-Packard management to limit or reduce the scope of its relationship with Canon would adversely affect Canon’s business and results of operations.
     Canon depends on a limited number of suppliers for certain key components.
     Canon relies on a limited number of outside vendors which meet Canon’s strict criteria for quality, efficiency and environmental friendliness for certain critical components used in its products. In some cases, Canon may be forced to discontinue its production of some or all of its products if certain vendors that supply key parts across Canon’s product lines experience unforeseen difficulties, or if such parts experience quality problems or are in short supply. Canon’s reliance on a limited number of suppliers involves several risks, including a potential inability to obtain an adequate supply of required components, the risk of untimely delivery of these subassemblies and components and the risk for a substantial increase in price of these components to occur. If such risks arise, Canon’s operating results will be adversely affected.

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     Although competition is increasing in the market for sales of supplies and services following initial product placement, Canon maintains a s high market share in sales of such supplies. As a result, Canon may be subject to antitrust-related suits, investigations or proceedings which may adversely affect its operating results or reputation.
     A portion of Canon’s net sales consists of sales of supplies and the provision of services occurring after the initial equipment placement. As these supplies and services have become more commoditized, the number of competitors in these markets has increased. Canon’s success in maintaining these post-placement sales will depend on its ability to compete successfully with these competitors, some of which may offer lower-priced products or services. Despite the increase in competitors as described above, Canon currently possesses a high market share in the market for supplies. Accordingly, Canon may be subject to suits, investigations or proceedings under relevant antitrust laws and regulations. Any such suits, investigations or proceedings may lead to substantial costs and have an adverse effect on Canon’s operating results or reputation.
     Recent increases in counterfeit Canon products may adversely affect Canon’s brand image and its operating results.
     In recent years, Canon has experienced a worldwide increase in the emergence of counterfeit Canon products. Such counterfeit products may diminish Canon’s brand image, particularly if purchasers of such products are unaware of their counterfeit status and attribute the counterfeit products’ poor product quality to Canon. Canon has been taking measures to halt the spread of counterfeit products. However, there is no assurance that such measures will be successful, and the continued production and sale of such products could negatively affect Canon’s brand image as well as its operating results.
     Per unit production costs are highest when a new product is introduced, and if such new products are not successful or if Canon fails to achieve cost reductions over time, Canon’s gross profits may be adversely affected.
     The unit cost of Canon’s products has historically been the highest when they are newly introduced into production and have at times had a negative impact on its gross profit, operating results and cash flow. Cost reductions and enhancements typically come over time through:
    engineering improvements;
    economies of scale;
    improvements in manufacturing processes; and
    improved serviceability of products.
     Initial shipments of Canon’s new products adversely affect its profit or cash flow, and if sales of such new products are not successful, Canon may be unable thereafter to improve its gross profit, operating results and cash flow.
     Cyclical patterns in sales of Canon’s products make planning and inventory management difficult and future financial results less predictable.
     Canon generally experiences seasonal trends in the sale of its consumer- oriented products, which results in sales fluctuations. Accordingly, it is difficult to predict near-term demand which as a result places pressure on Canon’s inventory management and logistics systems. If predicted demand is substantially greater than actual orders, there will be excess inventory, thereby putting downward pressure on selling prices and reducing Canon’s revenue. Alternatively, if orders substantially exceed predicted demand, Canon’s ability to fulfill orders may be limited, which could adversely affect net sales and increase the risk of unanticipated variations in its results of operation. Many of the factors that create and affect seasonal trends are beyond Canon’s control.
     Canon’s business may be subject to changes in sales environment.
     In certain geographic areas, particularly in Europe and the United States, a substantial portion of market share is concentrated in a relatively small number of large distributors. Canon’s sales of products to these distributors constitute a significant percentage of Canon’s overall sales. As a result, any disruptions in its relationships with these large distributors in a specific sales territory could adversely affect Canon’s ability to meet its sales targets. Any increase in the level of market share concentrated in these large distributors could result in Canon losing its pricing power and adversely affect its profits. In addition, the rapid proliferation of Internet-based businesses may render conventional distribution channels obsolete. These and other changes in Canon’s sales environment could adversely affect Canon’s results of operations.
     Canon is subject to financial and reputational risks due to product quality and liability issues.
     Although Canon has been working to minimize risks that may arise from product quality and liability issues, there can be no assurance that Canon will be able to eliminate or mitigate occurrences of these issues and consequent damages. If such factors adversely affect Canon’s operating activities, generate expenses such as those for product recalls, service and compensation, or hurt its brand image, its operating results or reputation for quality products may be adversely affected.
     Canon’s success depends on the value of its brand name, and if the value of the brand name were to diminish, operating results and prospects would be adversely affected.
     Canon’s success in its markets depends in part on Canon’s brand name and its value. In addition, as a manufacturer and distributor of consumer products, Canon’s operating results are susceptible to adverse publicity regarding the quality of its products. There can be no assurance that such adverse publicity will not occur or that such claims will not be made in the future. Furthermore, Canon cannot predict the impact of such adverse publicity on its business and results of operations.

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     A substantial portion of Canon’s business activity is conducted outside Japan, exposing Canon to the risks of international operations.
     A substantial portion of Canon’s business activity is conducted outside Japan, including in developing and emerging markets in Asia. There are a number of risks inherent in doing business in those markets, including the following:
    less developed technological infrastructure, which can affect production or other activities or result in lower customer acceptance of Canon’s services;
    difficulties in recruiting and retaining personnel;
    potentially adverse tax consequences;
    longer payment cycles;
    unfavorable political or economic factors; and
    unexpected legal or regulatory changes.
     Canon’s inability to manage successfully the risks inherent in its international activities could adversely affect its business and operating results.
     In order to produce Canon’s products competitively and to reduce costs, Canon has established new production facilities in China. Canon has more than ten sales office which support its sales activity in China. However, with China’s entry into the WTO, conditions within China are continuing to change. For example, unexpected events, including political or legal change, labor shortage or strikes, increased personnel costs or changes in economic conditions, may occur. In particular, a large revaluation of the yuan, or a sudden change in the tax system or other regulatory regimes of a significant magnitude could adversely affect Canon’s overall performance.
     In addition, the spread of an epidemic disease, such as severe acute respiratory syndrome (SARS) or the avian flu, in China or elsewhere in Asia could have a negative effect on Canon’s business activity. Canon has previously imposed travel restrictions to and from, certain countries affected by SARS, and similar medical crises in the future may disrupt manufacturing processes and markets for Canon’s products. Given the importance of Canon’s Asian sales, production facilities and supply relationships, especially in China, Canon’s business may be more exposed to this risk than the global economy generally.
     Canon may unintentionally infringe international trade laws and regulations, and any such infringement may lead to an adverse effect on its business. The extent of the effect on Canon’s business will depend upon the nature of the infringement and the severity of fines or other sanctions that might be imposed upon Canon. A major infringement could result in the temporary suspension of Canon’s trading rights in one or more jurisdictions. In addition to any sanctions prescribed by law, adverse publicity regarding an alleged infringement of trade laws and regulations by Canon may also have a negative effect on the Canon brand and image.
     All of the above factors regarding international operations could have an adverse impact on Canon’s business results.
     Canon depends on efficient logistics services to distribute its products worldwide.
     Canon depends on efficient logistics services to distribute its products worldwide. If problems arise with Canon’s computerized logistics system, or regional disputes or labor disputes, such as a dockworker’s strike, occur, it could lead to a disruption of Canon’s operations and result not only in increased logistical costs, but also in a loss of sales opportunities due to delays in delivery. Also, because demand for Canon’s consumer products can fluctuate throughout the year, the failure to adjust bookings for vessels and the preparation of warehouse space to reflect such fluctuations could result in either the loss of sales opportunities or the increase of unnecessary costs.
     In addition, the increasingly higher levels of precision required of semiconductor production equipment like steppers or mask aligners and the resulting increase in the value of this equipment in recent years have resulted in a concurrent increase in the need for sensitive handling and transportation of these products. Due to their precision nature, even a very trivial shock to these products during the handling and transportation process could result in loss on the entire product. If unforeseen accidents during the handling and transportation process render a significant portion of Canon’s higher-end precision products unmarketable, Canon may not be able to fully recover its investment in the research, development and production of these precision products.
     The rise in crude oil prices has become a recurring event, due primarily to the inflow of speculative funds into the global markets and the increasing consumption in China. As a result of this rise in oil prices, the cost of airfreight has increased in the form of a fuel surcharge. Such changes in the sales environment in which Canon operates could adversely affect Canon’s results of operations.
     Canon is engaging in the reduction of carbon dioxide emissions by implementing such measures as a new transportation system, including an efficient new rail container system. A failure by Canon to meet its targets may have a negative effect on Canon’s brand and image and its business.
     Economic trends in Canon’s major markets may adversely affect its results of operations net sales.
     Economic downturns and declines in consumption in Canon’s major markets, including Japan, the United States and Europe, may affect the levels of both corporate and consumer sales. Purchases of Canon’s consumer products, such as cameras and printers, are to a very significant degree discretionary. A decline in the level of consumption caused by the weakening of general economic conditions could adversely affect Canon’s results of operations.
     Canon’s operating results are also affected by the level of business activity of its customers, which in turn is affected by the level of economic activity in the industries and markets that they serve. A decline in the level of business activity of Canon’s customers caused by the weakening of the global economy could adversely affect Canon’s results of operations.

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Risks Related to Environmental Issues
     Canon’s business is subject to environmental laws and regulations.
     Canon is subject to certain Japanese and foreign environmental requirements in areas such as energy resource conservation, reduction of hazardous substances, collection and recycling of products, clean air, water protection and waste disposal. Canon believes that it has taken adequate precautions to comply with these regulations in the course of its ordinary business operations. Furthermore, Canon does not believe that any environmental laws or regulations currently in effect will have a material adverse effect on its operating results. However, Canon cannot predict whether any pending or future legislation will be adopted or what effect such legislation would have on it.
     In some cases, mainly in the European Union, such as with the Directive on the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment or the Directive establishing a framework for the setting of EcoDesign requirements for Energy-using Products, detailed implementation standards have not yet been determined. Canon intends to implement such standards as they are determined and adopted. If Canon’s measures do not meet such standards when they are adopted, however, Canon may be required to take further action and incur additional costs to comply with these regulations.
     Environmental clean-up and remediation costs relating to Canon’s properties and associated litigation could decrease Canon’s net cash flow, adversely affect its results of operations and impair its financial condition.
     Canon is subject to liability for the investigation and clean-up of environmental contamination at each of the properties that it owns or operates, at certain properties Canon formerly owned or operated and at off-site locations where Canon arranged for the disposal of hazardous substances. If Canon were to be held responsible for damages in any future litigation or proceedings, such costs may not be covered by insurance and may be material.
     In addition, Canon may face liability for alleged personal injury or property damage due to exposure to chemicals or other hazardous substances at or from its facilities. Canon may also face liability for personal injury, property damage, natural resource damage or for clean-up costs for the alleged migration of contamination or other hazardous substances from its facilities. A significant increase in the number or success of these claims and costs could adversely affect Canon’s results of operations or financial condition.
Risks Related to Intellectual Property
     Canon may be subject to intellectual property litigation and infringement claims, which could cause it to incur significant expenses or prevent it from selling its products.
     Because of the emphasis on product innovation in the markets for Canon’s products, many of which are subject to frequent technological innovations, patents and other intellectual property are an important competitive factor. Canon relies primarily on technology it has developed, and Canon seeks to protect such technology through a combination of patents, trademarks and other intellectual property rights.
     Canon faces the risks that:
    competitors will be able to develop similar technology independently;
    Canon’s pending patent applications may not be issued;
    the steps Canon takes to prevent misappropriation or infringement of its intellectual property may not be successful; and
    intellectual property laws may not adequately protect Canon’s intellectual property, particularly in some emerging markets.
     In case Canon is not aware of actual or potential infringement of, or adverse claim to, its rights in such technologies, any interference in Canon’s rights to use such technologies could adversely affect its operating results.
     In addition, Canon may need to litigate in order to enforce its patents, copyrights or other intellectual property rights, to protect its trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement, which can be expensive and time-consuming. In the event any government agency or third party were adjudicated to have a valid claim against Canon, Canon could be required to:
    refrain from selling the affected product in certain markets;
    make royalty payments or pay monetary damages;
    seek to develop non-infringing technologies, which may not be feasible; or
    seek to acquire licenses to the infringed technology, which may not be available on commercially reasonable terms, if at all.
     Canon also licenses its patents to third parties in exchange for payment or cross-licensing. The terms and conditions of such licensing or changes in the conditions for renewals of such licenses could affect Canon’s business.
     Canon’s businesses, company image and result of operations could be adversely affected by any of these developments.
     Disputes involving payment of remuneration for employee inventions may materially affect Canon’s brand image as well as its business.
     Canon may face disputes involving payment of remuneration given to employee inventions for which the rights have been succeeded by Canon. This risk is particularly relevant in countries such as Japan and Germany, where patent laws require companies to pay remuneration to employees for the succession of the employee’s invention to the company. Canon maintains company rules on and an evaluation system for employee inventions. Canon believes it has been making adequate payments to employees for assignment of inventions based on these rules and a fair and objective succession of amounts to be paid. There can be no assurance, however, that disputes will not arise with respect to the amount of payments to employees.

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Other Risks
     Canon depends on the attraction and retention of highly qualified professionals.
     Canon’s future operating results depend in significant part upon the continued contributions of its employees. In addition, Canon’s future operating results depend in part on its ability to attract, train and retain other qualified personnel in development, production, sales and management for Canon’s operations. The competition for these human resources in the high-tech industries in which Canon competes has been increasingly intense in recent years. Moreover, due to the accelerating pace of technological change, the importance of training new personnel in a timely manner to meet product research and development requirements will increase. A failure by Canon to recruit and train qualified personnel or the loss of key employees could adversely affect Canon’s business, and results of operations.
     Maintaining a high level of expertise in Canon’s manufacturing technology is critical to Cannon’s business. However, it is difficult to secure the expertise required for a special skills area, such as lens processing, in a short time period. While Canon is currently undertaking a series of planning in order to obtain the expertise needed for each skills area, Canon cannot guarantee that such expertise will be acquired in a timely manner and retained, which may adversely affect Canon’s business and results of operations.
     Canon’s physical facilities, information systems and information security systems are subject to damage as a result of disasters, outages or similar events.
     Canon’s headquarters functions, its information systems and its research and development centers are located in or near Tokyo, Japan, where the possibility of disaster or damage from earthquakes is generally higher than in other parts of the world. In addition, Canon’s facilities or offices, including those for research and development, material procurement, manufacturing, logistics, sales, and services are located throughout the world and subject to the possibility of disaster or outage or similar disruption as a result of any of a number of events, including natural disasters, computer viruses and terrorist attacks. Although Canon is working to establish appropriate backup structures for its facilities and information systems, there is no assurance that Canon will be able to completely prevent or mitigate the effect of events or developments such as the aforementioned disasters, leakage of harmful substances, shutdowns of information systems, and leakage, falsification, and disappearances of internal databases. Although Canon has implemented backup plans to permit the production of products at multiple production facilities, such plans do not cover all product models. In addition, such backup arrangements may not be adequate to maintain production quantity levels. Such factors may adversely affect Canon’s operating activities, generate expenses relating to physical or personal damage, or hurt Canon’s brand image, and its operating results may be adversely affected.
     Canon’s operating and financing activities expose Canon to foreign currency exchange and interest rate risks that may adversely affect its revenues and profitability.
     Canon is exposed to the risks of foreign currency exchange rate fluctuations. Canon’s consolidated financial statements, which are presented in Japanese yen, are affected by foreign exchange rate fluctuations. These fluctuations can affect the yen value of Canon’s equity investments denominated in foreign currencies and monetary assets and liabilities arising from business transactions in foreign currencies. They can also affect the costs and sales proceeds of products that are denominated in foreign currencies. In addition, as a result of translating foreign currency financial statements of Canon’s foreign subsidiaries into Japanese yen, its reporting currency, assets and liabilities, and revenues and expenses will fluctuate. Canon is also exposed to risk of interest rate fluctuations, which may affect the value of Canon’s financial assets and liabilities, in particular, long-term debt.
     The cooperation and alliances with, and strategic investments in, third parties undertaken by Canon may not produce successful results.
     Canon carries out many activities with other companies in the form of alliances, joint ventures, and strategic investments. These activities are important for Canon’s technological development process. However, weak business trends or disappointing performance by partners may adversely affect the success of these activities. In addition, the success of these activities may be adversely affected by the inability of Canon and its partners to successfully define and reach common objectives. An unexpected cancellation of a major business alliance may disrupt Canon’s overall business plans and may also result in a delayed return-on-investment.
     Canon can be adversely affected by fluctuations in the stock and bond markets.
     Canon’s assets include investments in publicly traded securities. As a result, Canon’s operating results and general financial position may be affected by fluctuations in the stock and bond markets. In addition, if valuations of investment assets decrease due to conditions in, for example, stock or bond markets, additional funding and accruals with respect to Canon’s pension and other obligations may be required, and such funding and accruals may adversely affect Canon’s operating results and consolidated financial condition.
     Confidential information may be inadvertently disclosed which could lead to damage claims or harm Canon’s reputation, and may have an adverse effect upon Canon’ s business.
     In connection with certain projects, Canon may receive confidential or sensitive information (such as personal information) from its customers relating to these customers or to other parties. In addition, Canon uses computer systems and electronic data in managing information relating to its employees. Although Canon makes every effort to keep this information confidential through company procedures designed to prevent accidental release of confidential or sensitive information, such information may be inadvertently disclosed without Canon’s knowledge. If this occurs, Canon may be subject to claims for damages from the parties or the employees affected, suffer harm to its reputation or be subject to liabilities and/or penalties under applicable statutes.
     Inadvertent disclosure of secret information regarding new technology, as well as market and customer information, would also have a material adverse effect upon Canon’s business.

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Item 4.   Information on the Company
     A.   History and development of the Company
     Canon Inc. is a joint stock corporation (kabushiki kaisha) formed under the Japanese Commercial Code. Its principal place of business is at 30-2, Shimomaruko 3-chome, Ohta-ku, Tokyo 146-8501, Japan. The telephone number is +81-3-3758-2111.
     The Company was incorporated under the laws of Japan on August 10, 1937 to produce and sell Japan’s first focal plane shutter 35mm still camera, which was developed by its predecessor company, Precision Optical Research Laboratories, which was organized in 1933.
     In the late 1950s, Canon entered the business machines field utilizing technology obtained through the development of photographic and optical products. With the successful introduction of electronic calculators in 1964, Canon continued to expand its operations to include plain paper copying machines, faxes, laser beam printers, bubble jet printers, computers, video camcorders and digital cameras.
     The following are important events in the development of Canon’s business in recent years.
    In 2000, the Canon Inc. Optics R&D Center, a research and development, or R&D facility for optical technology, was established in Tochigi, Japan.
 
    In 2000, Canon Inc. changed the listing of its American Depository Receipts (ADRs) to the New York Stock Exchange (NYSE) from the Nasdaq National Markets.
 
    In 2001, Canon Vietnam Co., Ltd. was established in Hanoi, Vietnam as a production site for bubble jet printers.
 
    In 2001, Canon Zhongshan Business Machines Co., Ltd. was established in Zhongshan, China as a production site for laser beam printers.
 
    In 2001, Canon (Suzhou) Inc. was established in Suzhou, China as a production site for digital copying machines and digital multifunction devices.
 
    In January 2003, Canon Aptex Inc. and Copyer Co., Ltd., two of Canon Inc.’s manufacturing subsidiaries in Japan, merged to become Canon Finetech Inc. The merger was conducted with the aim of concentrating and further strengthening the core competencies of the two merged companies in office equipment-related technologies.
 
    In April 2003, Fukushima Canon Inc. was established as a wholly-owned subsidiary through the spin-off of Fukushima Plant, with the aim of establishing a high value-added manufacturing company equipped with product-launching capability.
 
    In April 2003, Canon N.T.C.’s marketing operations were spun off and merged with Canon System & Support Inc., and its real estate operations were spun off into Canon Facility Management, Inc. Following the corporate spin-offs, Canon N.T.C.’s operations focuses on development and manufacturing.
 
    In January, 2004, Canon Precision Inc., or Canon Precision, a wholly-owned subsidiary of Canon Inc., merged with Hirosaki Precision, Inc., or Hirosaki Precision, a wholly-owned subsidiary of Canon Precision. Hirosaki Precision was merged into Canon Precision, the surviving company. Canon Precision targets the improved efficiency and specialization of business operations. Since both Canon Precision and Hirosaki Precision were consolidated subsidiaries of Canon Inc., the merger has no impact on Canon’s current or future business results.
 
    On October 15, 2004, the Company entered into an agreement with Canon Sales Co., Inc. and Canotec Co., Inc., or Canotec, joint equity shareholders of Niigata Canotec Co., Inc., or Niigata Canotec, to acquire all outstanding shares of Niigata Canotec. Therefore, on January 1, 2005, Niigata Canotec became a wholly-owned subsidiary of the Company and changed its name to Canon Imaging System Technologies Inc. By making Canon Imaging System Technologies, Inc. a wholly-owned subsidiary of the Company, Canon aims to raise the level of its technical capacity and improve development efficiency by enabling closer coordination.
 
    On January 1, 2005, Canotec and FastNet, Inc. merged, and the merged entity changed its name to Canon Network Communications, Inc. The purpose of the merger was to increase management efficiency by consolidating the Canon Group’s network and Internet service operations. Canon Network Communications, Inc. aims to strengthen Information Technology Management Services, dealing with all stages from the establishment of comprehensive network systems to their operation and management.
 
    On September 30, 2005, Canon acquired all of the issued and outstanding shares of ANELVA Corporation, which possesses advanced vacuum technology, and made it into a subsidiary. ANELVA Corporation’s corporate name was changed to Canon ANELVA Corporation as of October 1, 2005. By making Canon ANELVA Corporation a subsidiary of the Company, Canon aims to promote the in-house production of manufacturing equipment which is indispensable to differentiate Canon products from the competitions in various fields, including Canon’s new display business.
 
    On October 19, 2005, Canon acquired the share of NEC Machinery Corporation (listed on the Second Section of the Osaka Securities Exchange Co.,Ltd.), which possesses advanced automation technologies, through tender offer and made it into a subsidiary. NEC Machinery Corporation’s corporate name was changed to Canon Machinery Inc. as of December 17, 2005. By making Canon Machinery Inc. a subsidiary of the Company, Canon aims to make further advance in its production reform activities, including the automation of production processes for Canon products.
     In fiscal 2005, 2004 and 2003, Canon’s capital expenditures were Yen 383,784 million, Yen 318,730 million and Yen 210,038 million, respectively. In fiscal 2005, capital expenditures were mainly used to expand production capabilities in both domestic and overseas regions, and to bolster the Company’s R&D-related infrastructure. In addition, Canon has been continually investing in tools and dies for business machines, in which the amount invested is generally the same each year.

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     For fiscal 2006, Canon projects its capital expenditures will be approximately Yen 465,000 million. This amount is expected to be spent for investments in new production plants and new facilities of Canon. Canon anticipates that the funds needed for these capital expenditures will be generated internally through operations.
     B.   Business overview
     Canon is one of the world’s leading manufacturers of plain paper copying machines, digital multifunction devices, or MFDs, laser beam printers, bubble jet printers, cameras and steppers.
     Canon sells its products principally under the Canon brand name and through sales subsidiaries. Each of these subsidiaries is responsible for marketing and distribution to retail dealers in an assigned territory. Approximately 74% of consolidated net sales in fiscal 2005 were generated outside Japan; approximately 30% in the Americas, 32% in Europe and 12% in other areas including Asia.
     Canon’s strategy is to develop innovative, high value-added products which incorporate advanced technologies.
     Canon’s research and development activities range from basic research to product-oriented research directed at keeping and increasing the technological leadership of Canon’s products in the market.
     Canon manufactures the majority of its products in Japan, but in an effort to reduce currency exchange risks and production cost, Canon has increased overseas production and the use of local parts. Canon has manufacturing subsidiaries in countries and regions such as the United States, Germany, France, Taiwan, China, Malaysia, Thailand and Vietnam.
     As a concerned member of the world community, Canon emphasizes recycling, and has increased its use of clean energy sources and cleaner manufacturing processes. Canon has also adopted programs to collect and recycle used cartridges and to refurbish used copy machines. In addition, Canon has virtually removed all environmentally unfriendly chemicals from its manufacturing processes.
Products
     Canon’s products are divided into the following three product groups: business machines, cameras, and optical and other products.
-Business machines -
     The business machines product group is divided into three sub-groups consisting of office imaging products, computer peripherals and business information products.
     Office imaging products
     Canon manufactures, markets and services a wide range of office network digital MFDs, color network digital MFD’s, office copying machines, personal-use copying machines and full-color copying machines.
     The office-use market is subject to rapid change, and customer preferences have been shifting from copying machines to digital MFDs, as well as from monochrome to color products. To respond to these trends, Canon has been strengthening its lineup of digital MFDs in the imageRUNNER (iR) series, which have versatile functions, such as copying, printing, scanning, faxing and data-sharing functions on the Internet and intranets. Canon is also marketing diverse expansion modules, software and business solutions to increase customer value. For the development of MFDs, Canon makes effective use of a wide range of technologies from the fields of optics, mechatronics, electrophotography, chemistry and image processing. Canon has developed the high-performance image processing chip the “New color iR controller” and the expandable, functional platform “MEAP” The controller provides easy integration with customers’ IT environments together with speedy, high-quality image processing. This boosts office productivity, thereby garnering acclaim from business customers.
     In 2005, Sales of color office imaging products continued to grow rapidly as the office color market expanded and sales of monochrome digital devices were stable. Canon has expanded its color office imaging products lineups by introducing the iRC3170/2570 and iRC3220/2620 series worldwide to further increase color MFD sales. Canon has also introduced new monochrome MFD models to strengthen its industry leading monochrome MFD product lineup.
     Canon has a powerful line of full-color copying machines and color digital MFDs for users ranging from professional graphic designers to business offices. The trend in printing industry is gradually moving away from large-lot printing using expensive machinery to small-lot printing on demand and personalized printing. Canon’s high-end MFDs and color digital MFDs can be applied to the print on demand market. In addition, Canon aims to respond to the growing demand for color imaging for business needs with products using its renowned S Toner, featuring spherical particles and a microscopic wax-based structure, and its oil-less fixing system.
     Canon has a leading market share in monochrome MFDs and copying machines including machines for personal use. While the color shift is in progress, especially in Japan, the demand for monochrome machines is stable accompanying with the expansion of their multifunction capabilities and software development.
     With the evolution of digital technology and communication, MFDs that enable seamless conversion between paper documents and electronic documents have also evolved from being input-output devices to a sophisticated information systems. To deliver solutions that meet the diversifying needs of customers in various industries and niche, Canon has brought to market a full offering of MEAP-enabled office MFP lines both in monochrome and color as well as software products.
     The office imaging products category also includes the related sales of paper and chemicals, service charges and sales of replacement parts.

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     Computer peripherals
     Computer peripherals include laser beam printers (“LBP”), inkjet printers and scanners.
     Developed and fostered by Canon, laser beam printers are standard output peripherals for offices. Canon’s laser beam printers are relatively small in size and have high-quality printing capabilities attributable to Canon’s expertise in laser beam printing and plain paper copying technologies. Canon’s adoption of a user-replaceable toner cartridge system containing optical components makes its laser beam printers easy to maintain. Most of Canon’s laser beam printer sales are on an OEM basis. Canon also distributes Canon brand laser beam printers in Japan, Europe and Oceania.
     As for the monochrome laser beam printer, Canon has started to produce and sell sub-L products that belong to the lower segment of low-end products in Southern China. The unexpected expansion of production and selling has impelled Canon to the expansion of production in laser beam printers business.
     As the inventor of bubble jet printing technology, Canon believes it continues to provide customers with the best performance the technology has to offer. Canon provides high-performance and high value added models both in single-function printers and multi function printers. In response to intense competition in the inkjet printer segment, Canon has established a line-up of multifunction printers from flagship to entry models and, in 2005, launched several new models of single-function printers. All new model feature a print head called Canon Full-photolithography Inkjet Nozzle Engineering (FINE), which boosts print speed and image quality up to 9600 x 2400 dpi with microscopic droplets as small as one picoliter. In addition to high-quality images, Canon PIXMA branded photo printers offer advanced paper handling, such as dual paper path and two-sided duplex printing, and the new ChromaLife100 system for long-lasting photo prints. With these advanced printer line-ups, Canon has expanded its sales volume of both single-function printers and multi-function printers. Canon also expects the consumables business will expand accordingly.
     Canon markets a wide variety of scanners for a spectrum of user needs, including image scanners in the CanoScan LiDE series using Contact Image Sensor (CIS), and scanners with Charge-Coupled Devices (CCD) for high resolution in the CanoScan series. CIS is a close-contact method that allows a significant reduction in scanner weight and size. Canon has deployed its expertise to develop space-saving, energy-efficient scanners, as well as easy PC connection via universal serial bus interface. Although the scanner market has continued to shrink and shift to multi-function printers, Canon has successfully introduced new scanner models to attain a high market share.
     Business information products
     Business information products primarily consist of micrographic equipment, personal computers, calculators, document scanners and work stations.
     With the movement toward digitalization, the need to scan documents into text data or image data is expanding. Canon’s document scanners rapidly and efficiently digitize large volumes of information on paper. Canon offers a wide range of scanner models, including color capable compact sheet-fed types and a flatbed model suitable for book-type documents. Canon also offers a hybrid model that can create microfilm records while digitizing the information. Canon’s diverse lineup seeks to meet increased demands for digitizing office documents to share across Internet or intranet platforms or to capture data from forms with optical character recognition.
     Canon’s calculator operations, from development to production and marketing, are centered in Hong Kong. Canon’s tradition of technological innovation has been inherited by its personal information products, from calculators with printers to electronic dictionaries. Canon continues to develop distinct, appealing personal information products that reflect trends and demand.
     The work stations and personal computers sold by Canon are manufactured by third parties under the manufacturers’ own brand names.
- Cameras-
     Canon manufactures and markets digital cameras and film cameras. Canon also manufactures and markets digital video camcorders, lenses, and various camera accessories.
     DIGIC II, an improved and upgraded new image processor, is the distinguishing feature of Canon’s digital imaging equipment, including digital compact cameras, digital SLR cameras, and Compact Photo Printers. The DIGIC II has enhanced capabilities for high-quality image reproduction, high-speed data processing, and high quality movie image processing.
     In addition to aiming for the best possible image quality throughout its product lineup, Canon offers digital compact cameras that are easy to use with highly sophisticated product design. The compact digital camera market continued to grow in 2005 over 2004. Canon increased sales of compact digital cameras through the introduction of 13 new compact digital camera models in 2005. In 2005, new products, such as the Digital Elph SD400 (IXY 55 in Japan) and PowerShot A520/A510, were well-received in the market worldwide, and Canon increased its market shares and remained a leader in sales of compact digital cameras.
     In the Compact Photo Printer segment Canon has shown significant leadership in this market. Although the majority of the compact photo printer purchasers are considered “early adopters”, as market growth doubled in 2005, and retailers are now realizing the importance of this new business segment. Canon introduced 4 new compact photo printers under the series name Selphy in 2005. Canon has been able to leverage the brand recognition of its cameras to attract new customers for its compact photo printers. In addition, Canon is starting to realize profits from sales of consumables, such as paper and ink cartridges related to compact photo printers.
     The digital SLR market continues to expand. Canon introduced three new models of digital SLRs in 2005. Canon produces its own Complementary Metal Oxide Semiconductor (CMOS) imaging sensors, and each of the new models of digital SLRs were equipped with a different CMOS imaging sensor depending on the requirement of each camera, such as lens-compatibility, image quality, shooting speed, and affordability. Canon’s digital SLRs have been widely accepted by professional photographers and entry-level users alike.

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     In response to the strong increase in unit sales of digital cameras, Canon expanded its internet-based customer support service system in order to strengthen customer services.
     Although the conventional film cameras continues to decline, Canon intends to maintain its firm commitment to lead the film camera business, while closely monitoring the market trends.
     In the camera lens segment, technological developments, including diffractive optical elements, image stabilizers and ultrasonic motors, have helped Canon to maintain a technical lead over other makers. Canon offers over 50 lenses in the EF series. These high-quality, high-performance lenses provide outstanding performance with digital cameras as well as silver-halide cameras, greatly contributing to Canon’s sales. The market for interchangeable lenses, which are used for SLR cameras, has grown and aggregate sales of the interchangeable lens have increased every year for the past three years. In 2005, Canon launched a total of five new interchangeable lens models to the market, three of these were launched in the first half of 2005 and designed especially for digital SLR cameras. Demand for digital SLR cameras has recently increased significantly. In response to this trend, Canon intends to expand its sales and market share by introducing interchangeable lenses especially designed for digital SLR cameras, the market of which Canon expects to expand.
     Canon also provides full line-up of digital video camcorders from versatile, compact and stylish models to its flagship models for professionals. Canon’s digital video camcorders incorporate the same optical technologies and digital signal processing technology as its world-renowned cameras, and come equipped with its one-chip digital imaging processor (DIGIC DV) to ensure high image quality for both video and still images. Canon’s digital video camcorders are favored by many users for its optical performance, and red-green-blue primary color filters. The adoption of megapixel CCD, secure digital (SD) memory cards and universal serial bus (USB) connectivity offers a wealth of possibilities for the creation and management of still images, as well as video.
     The digital camcorder market continues to diversify, and, in 2005, Canon offered products for two new segments of the digital camcorder market in order to maintain its market position in that diversifying market. Until 2004, Canon was able to expand its market position by offering a full line-up of MiniDV camcorders. In the autumn of 2005, Canon began offering camcorders using DVD and camcorders with HD picture quality in addition to a full line-up of conventional MiniDV products. Canon’s first DVD camcorders, the DC20/DC10, were launched in September 2005, and Canon’s first HDV camcorder, XL H1, was launched in November 2005.
     Quality and performance such as high resolution, high brightness, and greater detail or sharpness are the key competitive factors in the market for projectors. At the end of fiscal 2004, Canon launched its independently developed, SXGA+ resolution projector SX50 that is equipped with reflective liquid crystals on silicon or LCOS technology. The SX50 features Canon’s proprietary optical system called AISYS to achieve significant improvements in brightness, size, and a price, as is well accepted in the high resolution projector market. Canon intends to introduce differentiated products as new trends in the market emerge.
-Optical and other products-
     Canon’s optical and other products includes semiconductor production equipment, medical equipment and electronic components.
     Semiconductor production equipment includes steppers and mask aligners. Steppers are used to expose circuits on silicon substrates. Canon has commercialized Krypton Fluoride excimer-laser steppers, Argon Fluoride excimer-laser steppers and i-line steppers. At the top of its class, the new Argon Fluoride excimer-laser scanning stepper the FPA-6000AS4 makes possible top-level throughput rates of over 92 wafers per hour (122 shots / wafer) for 300 mm wafers. In fiscal 2005, Canon introduced the FPA-6000ES6a, as its latest 300 mm-compatible lithography tool. The Canon FPA-6000ES6a is a Krypton Fluoride scanning stepper enabling top-level throughput rates of over 100 wafers per hour (122 shots / wafer). As a result of relatively weak investment by the semiconductor manufacturers in 2005, Canon’s stepper sales shrinked but unit base market share increased slightly compared with prior year. Canon, together with nine other Japanese semiconductor-industry companies, formed the Extreme Ultraviolet Lithography System Development Association. The consortium aims to develop key technology for next-generation lithography.
     Mask aligners are used to produce liquid crystal displays, or LCDs, and Canon’s model for large-sized LCD substrates are sold particularly well in line with increased demand for large flat panels for PC display and LCD televisions.
     Canon believes that, based on global units, it is the world leader in television broadcasting lenses, which are used to capture images from sports and news events, concerts and studio broadcasts. In fiscal 2005, the market for television broadcasting lenses continued to recover from the slump after 9/11, as a result of continued economic recovery and an ongoing global trend to introduce digital broadcasting equipment. In fiscal2005, Canon launched 7 new lens models primarily for television broadcasting digital cameras and maintained its position as the market leader for television broadcasting lenses.
     Medical equipment sold by Canon includes X-ray cameras, retinal cameras, autofractmeters and image-processing equipments for computerized diagnostic systems. Canon’s pioneering digital radiography system takes X-ray photography and medical diagnosis into the digital age.
     Other products sold by Canon include electronic components, such as magnetic heads for audio and video tape recorders and micro-motors for printers and other components, which are sold primarily to equipment manufacturers. Canon has also been developing a cost efficient solar-power system that incorporates amorphous silicon technology which is used in Canon’s high-end monochrome copying machines.

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Marketing and distribution
     Canon sells its products primarily through subsidiaries with responsibility for specific geographic areas. Each subsidiary is responsible for its own market research and for determining its sales channels, advertising and promotional activities.
     In Japan, Canon sells its products primarily through Canon Sales Co., Inc., mainly to dealers and retail outlets.
     In the Americas, Canon sells its products primarily through Canon U.S.A., Inc., Canon Canada, Inc. and Canon Latin America, Inc., mainly to dealers and retail outlets.
     In Europe, Canon sells its products primarily through Canon Europa N.V., which sells primarily through subsidiaries or independent distributors to dealers and retail outlets in each locality. In addition, copying machines are sold directly to end-users by Canon (U.K.) Ltd. in the United Kingdom, and by Canon France S.A.S. in France.
     In Southeast Asia and Oceania, Canon sells its products through subsidiaries located in those areas. In addition, copying machines are sold directly to end-users by Canon Australia Pty. Ltd. in Australia.
     Canon also sells laser beam printers on an OEM basis to Hewlett-Packard Company. Hewlett-Packard Company resells these printers under the “HP LaserJet Printers” name. During fiscal 2005, such sales constituted approximately 21% of Canon’s consolidated net sales, as compared to 21% in the previous fiscal year.
     Canon continues to enhance its distribution system by promoting continuing education of its sales personnel and improving inventory management and business planning through the weekly analysis of Canon’s sales data.
Service
     In Japan and overseas, product service is provided in part by independent retail outlets and designated service centers that receive technical training assistance from Canon. Canon also services its products directly.
     Most of Canon’s business machines carry warranties of varying terms depending upon the model and the country of sale. Cameras and camera accessories carry a one-year warranty based on normal use.
     Canon services its copying machines and supplies replacement drums, parts, toner and paper. In Japan, most customers enter into a maintenance service contract under which Canon provides maintenance services, replacement drums and parts in return for a per-copy charge. Copying machines which are not covered by a service contract may be serviced from time to time by Canon or local dealers for a fee.

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NET SALES BY PRODUCT GROUP
                                         
    Years ended December 31  
    2005     change     2004     change     2003  
    (Millions of yen except percentage data)  
Business machines:
                                       
Office imaging products
  ¥  1,153,240       2.9 %   ¥  1,120,972       3.6 %   ¥  1,081,995  
Computer peripherals
    1,244,906       8.3       1,149,914       5.6       1,089,312  
Business information products
    104,255       -10.9       117,067       -5.2       123,493  
 
                             
 
    2,502,401       4.8       2,387,953       4.1       2,294,800  
Cameras
    879,186       15.2       763,079       16.8       653,540  
Optical and other products
    372,604       17.6       316,821       26.9       249,732  
 
                             
Total
  ¥ 3,754,191       8.3     ¥ 3,467,853       8.4     ¥ 3,198,072  
 
                             
NET SALES BY GEOGRAPHIC AREA
                                         
    Years ended December 31  
    2005     change     2004     change     2003  
    (Millions of yen except percentage data)  
Japan
                                       
Unaffiliated customers
  ¥ 979,748       6.6 %   ¥ 919,153       7.3 %   ¥ 856,851  
Intersegment
    2,046,173       8.7       1,882,973       13.3       1,662,172  
Total
    3,025,921       8.0       2,802,126       11.2       2,519,023  
 
                             
Americas
                                       
Unaffiliated customers
  ¥ 1,139,784       7.8 %   ¥ 1,057,066       1.2 %   ¥ 1,044,998  
Intersegment
    7,424       -16.2       8,863       9.4       8,101  
Total
    1,147,208       7.6       1,065,929       1.2       1,053,099  
 
                             
Europe
                                       
Unaffiliated customers
  ¥ 1,178,672       8.1 %   ¥ 1,090,712       12.6 %   ¥ 968,938  
Intersegment
    2,206       -47.0       4,161       7.8       3,861  
Total
    1,180,878       7.9       1,094,873       12.5       972,799  
 
                             
Others
                                       
Unaffiliated customers
  ¥ 455,987       13.7 %   ¥ 400,922       22.5 %   ¥ 327,285  
Intersegment
    646,530       9.3       591,677       17.6       503,119  
Total
    1,102,517       11.1       992,599       19.5       830,404  
 
                             
Eliminations
                                       
Unaffiliated customers
  ¥       %   ¥       %   ¥  
Intersegment
    (2,702,333 )           (2,487,674 )           (2,177,253 )
Total
    (2,702,333 )           (2,487,674 )           (2,177,253 )
 
                             
Consolidated
                                       
Unaffiliated customers
  ¥ 3,754,191       8.3 %   ¥ 3,467,853       8.4 %   ¥ 3,198,072  
Intersegment
                             
Total
    3,754,191       8.3       3,467,853       8.4       3,198,072  
 
                             
Note:  The segments are defined under Japanese GAAP. In grouping of segment information by product, Japanese GAAP requires that consideration be given to similarities of product types and characteristics, manufacturing methods, sales markets, and other factors that are similar. In grouping of segment information by geographic area, Japanese GAAP requires that consideration be given to geographic proximity, as well as similarities of economic activities, interrelationships of business activities and similar factors. Segment information by geographic area is determined by the location of the Company or its relevant subsidiary making the sale.
Total operating profit by category is discussed in Item 5A “Operating Results”.

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Seasonality
     Canon’s sales for the 4th quarter are usually higher than those in the other three quarters, mainly owing to strong demand for consumer products, such as cameras and bubble jet printers, during the year-end holiday season. In Japan, corporate demand for office products peaks in the 1st quarter, as many Japanese companies close their books in March. Sales also tend to increase at the start of the new school year in each of the respective regions.
Sources of supply
     Canon purchases materials such as glass, aluminums, plastics, steels, and chemicals for using it for various kinds of parts or manufacturing products. With the development of globalization in production, we procure raw material from all over the world, and we select suppliers based on a number of criteria, including environmental friendliness, quality, cost, supply stability, and financial condition.
     Prices of some raw materials fluctuate according to the market. Due to the high price of crude oil and increase in demand toward China, the market place is tight since the beginning of the year. However, Canon believes it will be able to continue to obtain sufficient quantities of raw materials to meet its needs.
     Canon places significant emphasis on in-house development of production tools. Canon also produces many of the tuning and measuring tools needed for the development, maintenance and repair of its production equipment. Key tools such as these are not marketed for sale; they are reserved for use within the Canon Group. Canon’s ability to develop its own production tools helps establish quality control and allows for speed and flexibility when retooling is necessary — a crucial advantage in its cell production processes. Cell production is the production system in which the entire production process is undertaken by small groups of employees. In-house tool development may also help cut costs over time and prevent the leakage of Canon’s core proprietary technologies.
Competition
     Canon encounters intense competition in all areas of its business activity throughout the world. Canon’s competitors range from some of the world’s major multinational corporations to smaller, highly specialized companies. Canon competes in a number of different business areas, whereas many of its competitors are relatively more focused on one or more individual industries. Consequently, Canon may face significant competition from entities that apply greater financial, technological, sales and marketing or other resources than Canon to their activities in a particular market segment.
     The principal elements of competition which Canon faces in each of its markets are technology, quality, reliability, performance, price and customer service and support. Canon believes that much of its ability to compete effectively depends on conducting successful research and development activities that enable it to create new or improved products and release them on a timely basis and at commercially attractive prices.
     The competitive environments in which each product group operates are described below:
    Business machines
     The markets for office imaging products, computer peripherals and business information products are highly competitive. Canon’s primary competitors in these markets are Xerox Corporation/ Fuji Xerox Corporation, Hewlett-Packard Company, Lexmark International Group Inc., Ricoh Company, Ltd., Konica Minolta Holdings, Inc. and Epson Corporation. Canon believes that it is one of the leading global manufacturers of copying machines, digital MFDs, laser beam printers, bubble jet printers, image scanners and facsimile machines. In addition to the general elements of competition described above, Canon’s ability to compete successfully in these markets also depends significantly on whether it can provide effective, broad-based “business solutions” to its customers that solve multiple interrelated client needs. In particular, the ability to provide equipment and software that connect effectively to networks (ranging in scope from local area networks to the Internet) is often a key to Canon’s competitive strength in these markets. In China, whose markets are expected to expand since joining of the World Trade Organization, the current market leaders are Toshiba Tec Corporation, Sharp Corporation and Konica Minolta Holdings, Inc. Canon is joining this top group by the introduction of products suited to the market and by the reinforcement of sales and service channels. Also in regards to the office color market, in addition to Ricoh and Xerox, Konica Minolta has been very aggressive with its color strategy especially in Europe and the US, and competition in this market has become fierce.
     Also, as a recent trend, convergence of the copier industry and the printer industry has become apparent. Competition at the low-end segment has turned especially fierce by the impact of printer-based MFDs on copier market. Canon sees this market convergence as a growth opportunity and has enhanced its printer and printer-based MFP lineups. Canon also ensures to differentiate itself from other competitors by offering comprehensive solutions to customers.
    Cameras
     Competition in the camera industry is intense, with many established market participants offering superior products with competitive pricing. Canon’s primary competitors in digital cameras are Sony Corporation, Fuji Photo Film Co., Ltd., Olympus Corporation, Nikon Corporation, Casio Computer Co., Ltd., Matsushita Electric Industrial Co., Ltd., and Eastman Kodak Company.
     In the digital SLR market, Canon took the early lead over Nikon have gained more than 50% of the market share, turning over complete lineup with healthy life cycle, while other manufacturers struggled to increase their market share. However, the competition is expected to become tougher in 2006, with more newcomers with aggressive approach into the lucrative-looking market. Canon is committed to keep leading the digital SLR market, with aggressive investment to develop new models.
     Canon’s primary competitor in the lens market is Nikon Corporation whose popular class digital single-lens reflex cameras are selling well. Another major competitor is Sigma Corporation, which sells products that are compatible with Canon’s single-lens reflex camera lens.
     In the declining market, competitions in the conventional film camera market is now seems to be limited, such as Nikon Corporation in the SLR, and Olympus Corporation for the compact cameras. Canon is committed to successfully retain a leading global market-share for SLR cameras, and maintain its position as one of the leading compact film camera manufacturers, while maintaining profitability.

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     In Compact Digital Still Camera (“DSC”) segment industry’s price drop trends will continue in 2006 and it will become tougher to maintain ongoing profit level. Also, the market in the economically developed countries have seem to be matured.
     While we see the above-mentioned tough signs, we also see many positive signs as well. For instance, as China and Eastern Europe including Russia have shown significant growth, Canon has increased its business accordingly since Canon has already established fairly good position in those areas as well. Also, Canon’s products’ cost down efforts have shown very positive progress utilizing the advantages of significant scale merit as a world No.1 manufacture. In these sense we believe Canon’s compact DSC business will continue to be positive toward the following year.
     Canon’s primary competitors in digital video camcorders are Sony Corporation, Matsushita Electric Industrial Co., Ltd., Victor Company of Japan Ltd. and Samsung Electronics Co., Ltd. In fiscal 2005, Canon introduced DVD camcorders as well as HDV camcorders to compete with them for continuous expand of its sales in overall market in digital video camcorders.
    Steppers and Aligners
     The market for steppers and aligners, used in the manufacture of semiconductor devices and LCDs, is highly competitive. The market is characterized by a relatively small number of dominant suppliers, since the development of steppers and aligners requires extremely precise design and manufacturing techniques and, as a result, very high levels of capital investment.
     Canon’s primary competitors in the market for steppers and aligners are Nikon Corporation and ASML Holding N.V., or ASML. Nikon Corporation has a reputation for its excellent technology, especially optical lenses, and Intel Corporation, the world’s leading semiconductor manufacturer, is one of their major customers. ASML has in recent years improved its competitive position by taking advantage of government subsidies and by focusing on the rapidly growing foundry manufacturer industry. In fiscal 2002, ASML further increased its competitive position by acquiring SVG Lithography Systems Inc. As a result of the acquisition, ASML is now one of the largest semiconductor manufacturing equipment companies in Europe.
     Because of the substantial capital expenditures required to install and integrate equipment into a semiconductor production line, semiconductor manufacturers tend to purchase their stepper and aligner production equipment from the vendor that originally supplied the chip fabrication equipment. Canon competes principally on its ability to meet and exceed product specifications, including resolution and throughput, quality, reliability and system maintenance cost. Because of the very rapid pace of technological innovation in the semiconductor industry, Canon also believes that its ability to provide new products on a timely basis is also a key competitive consideration for customers seeking to integrate stepper and aligner production systems into the planning and design of their new facilities.
Patents and licenses
     Canon holds a large number of patents (including utility model rights), design rights and trademarks in Japan and abroad to protect its technology products that arise from its research and development and utilizes these intellectual property rights as important strategic management tools. For instance, Canon has been utilizing its intellectual property rights such as patents to expand its products business operations and to form alliances and exchange technologies, with other companies.
     According to the Statistical Report issued annually by the United States Patent and Trademark Office, Canon has been consistently ranked as second or third in recent years in terms of the number of patents issued in the United States, as Canon maintained reputation as a famous technology-oriented company.
     Canon has granted licenses with respect to its patents to various Japanese and foreign companies, particularly in areas such as electrophotography, laser beam printers, multifunction printers, facsimiles and cameras.
     Some examples include:
     
Oki Electric Industry Co., Ltd.
  (LED printers, multifunction printers and facsimiles)
Matsushita Electric Industrial Co., Ltd.
  (electrophotography)
Ricoh Company, Ltd.
  (electrophotography)
Sanyo Electric Co., Ltd.
  (electronic still camera)
Samsung Electronics Co., Ltd.
  (laser beam printers, multifunction printers and facsimiles)
Brother Industries, Ltd.
  (electrophotography and facsimiles)
Kyocera Mita Corporation
  (electrophotography)
Konica Minolta Holding Co.,Ltd.
  (business machines)
Toshiba Corporation
  (business machines)
     Canon has also been granted licenses with respect to patents held by other companies.
     Some examples include:
     
Jerome H. Lemelson Patent Incentives, Inc.
  (computer systems, image recording apparatus, and communication apparatus)
Energy Conversion Devices, Inc.
  (solar battery)
Honeywell Inc.
  (camera and video products)
Gilbert P. Hyatt U.S. Philips Corporation
  (microcomputer)
Nano-Proprietary Inc.
  (FED technology)

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     Canon has also entered into cross-licensing agreements with other major industry participants.
     Some examples include:
     
International Business Machines Corporation
  (information handling systems)
Hewlett-Packard Company
  (bubble jet printers)
Xerox Corporation
  (business machines)
Matsushita Electric Industrial Co., Ltd.
  (video tape recorders and video cameras)
Eastman Kodak Co.
  (electro-photography and image processing technology)
Ricoh Company, Ltd.
  (electrophotography products, facsimiles and word processors)
     Canon has placed high priority on the management of its intellectual property as part of its management strategies to enhance its global business operations. Some products which are material to Canon’s operating results, incorporate patented technology which is critical to the continued success of these products. Typically, these products incorporate technology reflected in dozens of different patents. Canon does not believe that its business, as a whole, is dependent on, or that its profitability would be materially affected by the revocation, termination, expiration or infringement upon, any particular patent, copyright, license or intellectual property rights or group thereof.
Environmental regulations
     Canon is subject to a wide variety of laws and regulations as well as industry standards relating to energy and resource conservation, recycling, global warming, pollution prevention, pollution remediation, and environmental health and safety. Some of the environmental laws which affect Canon’s businesses are summarized below.
1.   European Union Directive on the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment or RoHS Directive, and Directive on Waste Electrical and Electronic Equipment or WEEE Directive.
     These directives were published in the European Union’s Official Journal on February 13, 2003. Member states were required to bring into force the laws necessary to comply with these directives by August 13, 2004. Commencing July 1, 2006, companies must ensure that their electrical and electronic equipment sold in the European Union does not contain lead, cadmium, hexavalent chromium, mercury, polybrominated biphenyls or polybrominated diphenyl ethers if placed on the market after that date. Pursuant to the RoHS Directive, Canon will be required to adapt its products so that they do not contain the prohibited hazardous substances.
     The WEEE Directive requires that after August 13, 2005, companies that sell electrical and electronic equipment bearing their trade names in the European Union must arrange and pay for the collection, treatment, recycling, recovery and disposal of their equipment and achieve designated recycling rates by December 31, 2006. Pursuant to the WEEE Directive, Canon is joining a collective compliance scheme for WEEE Directive in each member state, and will achieve the recycling ratio of waste electrical and electronic equipment through these schemes by the target date. The increased cost associated with the WEEE Directive may adversely affect Canon’s results of operations.
2.   Soil Pollution Prevention Law of Japan
     The Soil Pollution Prevention Law of Japan, administered by the Japanese Ministry of the Environment, went into effect in February 2003. The law requires an owner of land to have the soil investigated by a designated organization for the purpose of measuring the level of soil pollution when the land is to be transferred or to be used for another purpose. The results of such investigation are reported to the prefectural governor. If the soil pollution is not within standards specified in the law, the governor will designate the land as “a designated area”, publicly announce such designation and make available upon request the investigation report. The substances designated in the law consist of 25 chemical groups, including substances such as lead, arsenic, and trichloro ethylene. If there is a possibility that the soil pollution of the designated area may affect human health, the governor will issue an order to the land owner to take remedial actions.
     In response to the law, Canon had commenced a detailed survey and measurement of soil and groundwater to determine the existence of pollution at all of Canon Group’s operational sites in Japan. Additional costs may arise as remedial measures become necessary. These factors may adversely affect Canon’s results of operations and financial conditions.
     See “Risk Factors — Risks Related to Environmental Issues — Environmental clean-up and remediation costs relating to Canon’s properties and associated litigation could decrease Canon’s net cash flow, adversely affect its results of operations and impair its financial condition.”
3.   Law for Promotion of Effective Utilization of Resources of Japan
     The Law for Promotion of Effective Utilization of Resources of Japan, administered by the Japanese Ministry of Economy, Trade and Industry, was enacted in April 2001. This Law requires manufacturers of “specified reuse-promoted products”, including copiers, to promote the use of recyclable resources and recovered products (designing and manufacturing products that can be easily reused or recycled). These requirements will increase Canon’s costs and may have an adverse affect on its results of operations.
     This law will be amended to require the producers of covered products to mark their products manufactured on and after July 1, 2006 with an orange “content mark” when they contain any of 6 substances restricted by EU RoHS Directive. If products do not contain these 6 substances, they can be marked with “green mark” voluntarily. This marking system is called Japan-Marking of Special Substances, or “J-MOSS,” and is provided by JIS C 0950:2005 standards. Although the copying machines do not have to be marked with these “content marks” at present, they will surely be covered by the requirement in the future. We expect that this new requirement will have influence on the green procurement of Japanese governmental agencies and might have some effect on Canon’s business.

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4.   Law on Promoting Green Purchasing of Japan
     The Law on Promoting Green Purchasing of Japan, administered by the Japanese Ministry of the Environment, took effect in April 2001. The law encourages both national and local governments to procure products with low environmental burdens. Businesses are required to provide information that is necessary to determine the environmental impact of products that they manufacture.
     In response to the law, Canon now promotes to:
    manufacture products that consume less electricity to prevent global warming and to conserve energy,
    use recycled parts and recycled materials,
    reduce the types of raw materials used in order to conserve resources, and
    accelerate the date by which the requirements of the law are implemented to promote the elimination of hazardous substances.
     The law also requires Canon to collect its used products and recycle them, establish alternative technologies for hazardous substances used in products and standardize the substances used in its products. These measures will entail additional costs and may adversely affect its results of operations and financial conditions.
5.   Draft European Union Directive on Batteries and Accumulators and Spent Batteries and Accumulators
     On November 21, 2003, the European Commission proposed a draft Directive on Batteries and Accumulators and Spent Batteries and Accumulators to replace a similar existing directive. In November 2005, the European Parliament started its second reading of this matter. Whereas the existing directive applies only to batteries with a certain mercury, cadmium and lead content, the new directive applies to all batteries and accumulators placed on the European Community market. When enacted, the new directive will require specified labels on all batteries. In addition, the directive establishes specific targets for collection, treatment and recycling of batteries and accumulators. Canon expects that compliance with the directive will increase its financial costs such as recycling fees and guarantees of products placed on the market.
6.   Clean Production Promotion Law of China
     The Clean Production Promotion Law of China, administered by the standing committee of the National people’s congress, effective as of January 1, 2003, provides, among other things, for environmentally conscious design, elimination of hazardous substances, ease of disassembly, material identification, collection and recycling. The Chinese government is expected to publish a list of products to be collected, but it is yet unclear what action Canon needs to take at the present time.
7.   Administrative Measures on the Control of Pollution Caused by Electronic Information Products of China
     Modeled on the European Union RoHS Directive described above, the Chinese Ministry of Information Industry published Administrative Measures on the Control of Pollution Caused by Electronic Information Products on February 28, 2006. These measures regulate the content of electronic information products, and will be implemented as of March 1, 2007. All the electronic information products would have to put a certain China specific mark on them and to show their contents of the EU RoHS substances. In addition, the content of 6 substances in specific electronic information products (those specified in the “list for emphasized management”) would be restricted by the similar limitation of the EU RoHS Directive, and China specific compulsory products certification system will be introduced for such products. However, the standards to implement these measures, and the “emphatic management list” have not been published. These requirements will increase Canon’s costs and may have an adverse affect on its results of operations and financial conditions.
8.   Executive Order of the United States
     The Executive Order 13221 Energy Efficient Standby Power Devices, published on August 2, 2001 and amended on September 3, 2004 (Administered by U.S. Department of Energy), requires the Federal Government to purchase consumer products that use no more than one watt (two watt for a product with a facsimile function) in their standby power consuming mode. Canon’s products such as laser beam printer, MFP and FAX need to have a hard switch or they need to incorporate energy conserving designs which reduce the energy consumption at the standby mode to meet the require watts.
9.   The European Framework for the management of chemical substances, or REACH Regulations
     The European Union is currently considering the REACH Regulations which would establish a framework for the management scheme for all the commercial chemical substances. This framework, if adopted, would apply to almost all the chemicals (that is, products in gaseous, liquid, paste or powdery form) and some of the “articles” (products in solid state) manufactured in or imported into the European Union. All the chemicals manufactured/imported over specific threshold would have to register in the European Union and provide information about their usage or their chemical characters, etc., and use of substances regarded as “dangerous” might be prohibited. The Regulations are still under discussion in the European Parliament and the Council and the final details are unclear yet, but if such requirements are enacted, they might increase Canon’s costs.
10.   The European Framework for the Setting of Requirements for Energy-Using Products (so-called “EuP directive”)
     The European Union published the directive that would establish a framework for the setting of environmental requirements for energy-using products, or the “EuP directive”, in July 22, 2005. Member states are required to bring into force the laws necessary to comply with the directive concerning eco-design by August 11, 2007. This framework directive would apply to all products that use energy, and under this directive, “implementing measures” for specific product categories would be adopted by the European Commission and the member states. Until these implementing measures are clarified, it is difficult to estimate the concrete effects of the EuP directive. But one of the first implement measures is expected to require that covered products should not use more than 1 watt (2 watts for a product with a facsimile function) in their standby mode, like the U.S. Executive Order 13221 mentioned in paragraph 8 above.

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11.   Kyoto Protocol to the United Nations Framework Convention on Climate Change
     The Kyoto Protocol to the United Nations Framework Convention on Climate Change entered into force on February 16, 2005 as Russia ratified it in November 2004.
     In order to achieve a goal set in the Kyoto Protocol, a Kyoto Protocol Target Achievement Plan was issued by the Japanese Government and decided at a Cabinet Meeting in April, 2005 and ensuing revision of Energy Conservation Law as well as Global Warming Prevention Promotion Law will come into force in April, 2006.
     Canon will try to achieve its voluntary action plan that corresponds to voluntary action plan of Electric & Electronic Industry Associations to which Canon belongs and comply with the revised laws and submit information and plans required by the Japanese Government. However, Canon further expects that the Japanese Government might adopt stricter measures to let Japanese industries achieve their voluntary action plans by all means or other scheme to let Japanese nation share part of costs to achieve the Japanese goal by means of an environment taxation, etc. Therefore, Canon will carefully monitor the Japanese Government and consider a contingency plan, among others, including a Kyoto Mechanism.
     C.   Organizational structure
     Canon Inc. and its subsidiaries and affiliates form a group of which Canon Inc. is the parent company. As of December 31, 2005, Canon had 200 consolidated subsidiaries and 13 affiliated companies accounted for by the equity method.
     The following table lists the significant subsidiaries owned by Canon Inc., all of which are consolidated, as of December 31, 2005.
                     
        Proportion of     Proportion of  
        ownership interest     voting power  
Name of company   Head office location   owned     held  
Canon Sales Co., Inc.
  Tokyo, Japan     50.3 %     51.1 %
Canon U.S.A., Inc.
  New York, U.S.A.     100.0 %     100.0 %
Canon Europa N.V.
  Amstelveen, The Netherlands     100.0 %     100.0 %

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     D.   Property, plants and equipment
     Canon’s manufacturing is conducted primarily at 23 plants in Japan and 17 plants in other countries. Canon owns all of the buildings and the land on which its plants are located, with the exception of certain leases of land and floor space of certain of its subsidiaries. The names and locations of Canon’s plants and other facilities, their approximate floor space and the principal activities and products manufactured therein as at December 31, 2005 are as follows:
             
    Floor space    
    (including    
Name and location   leased space)   Principal activities and products manufactured
Domestic   (Thousands of    
    square feet)    
 
           
Headquarters, Tokyo
    2,267     R&D, corporate administration, other functions
 
           
Mizonokuchi Human Resources Development center, Kanagawa
    78     Human Resources Development Training & administration
 
           
Kosugi Office, Kanagawa
    398     Development of software for office imaging products
 
           
Fuji-Susono Research Park, Shizuoka
    1,038     R&D in electrophotographic technologies
 
           
Hiratsuka Development Center, Kanagawa
    375     Development of displays, electronic devices
 
           
Ayase Office, Kanagawa
    394     R&D and manufacturing of semiconductor devices
 
           
Optics R&D Center, Tochigi
    473     R&D in optical technologies, development of broadcasting equipment
 
           
Tamagawa Plant, Kanagawa
    434     Development of Ink Jet printers, Ink Jet chemical products
 
           
Yako Development Center, Kanagawa
    509     Development of inkjet printers, Ink Jet chemical products
 
           
Utsunomiya Plant, Tochigi
    1,442     Manufacturing of EF lenses, video camcorder lenses, broadcasting lenses, lenses for business machines, other specialized optical lenses
 
           
Toride Plant, Ibaraki
    2,910     R&D in electrophotographic technologies, mass-production trials and support; manufacturing of chemical products
 
           
Ami Plant, Ibaraki
    1,338     Manufacturing of office imaging products, chemical products, semiconductor production equipment; design and manufacturing of factory automation equipment and metal molds
 
           
Utsunomiya Optical Products Plant, Tochigi
    1,420     R&D, manufacturing, sales and servicing of semiconductor equipment; sales of broadcasting equipment; R&D and sales of medical equipment
 
           
Canon Electronics Inc., Saitama and Gunma
    1,074     Development, production and sales of camera components, magnetic heads, sensors, micrographics, document scanners, LBPs, laser scanner units, portable data terminals, semiconductor equipment
 
           
Canon Finetech Inc, Ibaraki, Tokyo, Yamanashi, and Fukui
    899     Production and sales of business machines, business machine peripherals, chemical products, business-use printers
 
           
Canon Precision Inc., Aomori
    1,280     Development, production and sales of motors; production of toner cartridges, sensors
 
           
Optron Inc., Ibaraki
    150     Polishing of optical crystals (for steppers, cameras, telescopes), vapor deposition materials

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    Floor space    
    (including    
Name and location   leased space)   Principal activities and products manufactured
Domestic   (Thousands of    
    square feet)    
 
           
Canon Chemicals Inc., Ibaraki
    1,756     Toner cartridges and advanced-function parts, plastic precision-molded parts, metal molds
 
           
Canon Components Inc., Saitama
    430     Image sensor units, printed circuit boards, Ink Jet print heads/ink tanks
 
           
Oita Canon Inc., Oita
    1,149     SLR cameras, digital SLR and compact cameras, digital video camcorders, visual communication cameras
 
           
Nagahama Canon Inc., Shiga
    1,059     LBPs, toner cartridges, a-si drums, Ink Jet print heads/ink tanks
 
           
Oita Canon Materials Inc., Oita
    1,201     Chemical products for copying machines and printers
 
           
Ueno Canon Materials Inc., Mie
    541     Chemical products for copying machines and printers
 
           
Fukushima Canon Inc., Fukushima
    970     Production of inkjet printers, Ink Jet print heads/ink tanks; analysis of software and fonts
 
           
Canon Semiconductor Equipment Inc., Ibaraki
    583     Development and production of semiconductor production-related equipment; production of small-sized copying machines and copying units
 
           
Canon Ecology Industry Inc., Ibaraki and Saitama
    329     Recycling of toner cartridges; business machine repair
 
           
Nisca Corporation, Yamanashi
    470     Development, design, production and sales of business machines, information products, optical equipment
 
           
Miyazaki Daishin Canon Co., Ltd., Miyazaki
    121     Digital video camcorders, digital cameras, electronics packaging
 
           
Canon ANELVA Corporation
    562     Electron devices, panel devices, electronic components for R&D
 
           
Canon Machinery Inc.
    296     Semiconductor, electronic components, energy relation
 
           
SED Inc.
    291     Flat-screen SED (Surface-conduction Electron-emitter Display) panels

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    Floor space    
    (including    
Name and location   leased space)   Principal activities and products manufactured
Overseas   (Thousands of    
    square feet)    
 
           
[Europe]
           
 
           
Canon Giessen GmbH, Giessen, Germany
    362     Production and remanufacturing of copying machines; refilling of toner cartridges; remanufacturing of semiconductor production equipment
 
           
Canon Bretagne S.A.S., Liffre, France
    506     Production of low-speed copying machines and toner cartridges; recycling of toner cartridges
 
           
[America]
           
 
           
Canon Virginia, Inc., Virginia, U.S.
    828     Production of LBPs, toner cartridges, toner for copying machines
 
           
[Asia]
           
 
           
Canon Inc., Taiwan, Taiwan
    414     Production of SLR and compact cameras, EFS and other lenses, precision-metal molds
 
           
Canon Opto (Malaysia) Sdn. Bhd., Selangor, Malaysia
    551     Production of Digital cameras, EF lenses, optical lens parts
 
           
Canon Dalian Business Machines, Inc., Dalian China
    1,095     Production and recycling of toner cartridges; production of LBPs, MFDs
 
           
Cannon Zhuhai, Inc., Zhuhai, China
    678     Production of Compact cameras, digital cameras, LBPs, MFDs, image scanners, contact image sensors
 
           
Tianjin Canon Inc., Tianjin, China
    148     Production and sales of copying machines
 
           
Canon Hi-Tech (Thailand) Ltd., Ayutthaya, Thailand
    976     Ink Jet printers, personal-use copying machines, facsimile machines, MFDs
 
           
Canon Engineering (Thailand) Ltd., Ayutthaya, Thailand
    129     Metal molds, plastic injection mold parts
 
           
Canon Zhongshan Business Machines Co., Ltd., Zhongshan, China
    492     Production of laser beam printers
 
           
Canon Vietnam Co., Ltd., Hanoi, Vietnam
    1,043     Production of Ink Jet printers
 
           
Canon (Suzhou) Inc., Suzhou, China
    797     Production of Color and monochrome digital copying machines
 
           
Canon Finetech (Suzhou) Business Machines Inc., Suzhou, China
    305     Production of digital printers, peripherals, service parts
 
           
Thai Nisca Co. Ltd., Ayutthaya, Thailand
    190     Production and sales of optical equipment and OA equipment
 
           
Canon Finetech Industries Development Co., Ltd., Shenzhen, China
    215     Production and sales of copying machines, semi-finished products, parts
 
           
Canon Ayutthaya (Thailand) Ltd., Thailand
    182     Ink Jet printers, personal-use copying machines, facsimile machines, MFDs
     Canon considers its manufacturing and other facilities to be well maintained and believes that its plant capacity is adequate for its current requirements. At December 31, 2005, land, buildings and related equipment with a book value of Yen 7,423 million were subject to mortgages securing Yen 2,227 million of Canon’s indebtedness.

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Item 5.   Operating and Financial Review and Prospects
     A.   Operating Results
     The following discussion and analysis provides information that management believes to be relevant to understanding Canon’s consolidated financial condition and result of operations.
Overview
     Canon is one of the world’s leading manufacturers of copying machines, laser beam printers, inkjet printers, cameras, steppers and aligners. Canon earns revenues primarily from the manufacture and sale of these products domestically and internationally. Canon’s basic management policy is to contribute to the prosperity and well-being of the world while endeavoring to become a truly excellent global corporate group targeting continued growth and development.
     Canon divides its businesses into three product groups: business machines, cameras and optical and other products. The business machines product group has three sub-groups: office imaging products, computer peripherals and business information products.
Economic environment
     Looking back at the global economy in 2005, the U.S. economy continued to display growth despite concern over the economic impact of escalating crude oil prices and the damage caused by Hurricane Katrina, with healthy employment conditions and continued growth in consumer spending. In Europe, while the recovery in consumer spending appeared to falter, such factors as growth in the production sector amid strong exports indicate a trend toward moderate recovery. As for Asia, China continued to achieve a high rate of economic growth, mainly fueled by exports, while other Asian economies also recorded generally favorable performances. In Japan, the economy continued to gradually recover owning to such factors as increased corporate investment supported by favorable corporate profits and improved consumer spending.
Market environment
     With respect to the markets in which Canon operates, demand in the digital camera segment for single lens reflex (“SLR”) models continued to grow significantly during fiscal 2005. Sales of digital compact cameras also remained strong to realize healthy overall growth for the segment. Demand for network digital multifunction devices (“MFDs”) remained solid as the office market, including small-scale enterprises, moved toward color and multifunctionality. Although sales of computer peripherals, including printers, grew for both multifunction and color models, the segment suffered amid a shift in further demand toward high-performance low-priced machines and severe price competition. Demand for steppers, used in the production of semiconductors, tapered off after the summer of 2004 as the chip manufacturing market entered a correction phase. The market for projection aligners, which are used in the production of liquid crystal display (“LCD”) panels, enjoyed stable growth, fueled by increased investment by LCD panel manufacturers amid the rapid expansion of the LCD television market. The average value of the yen for the year was Yen 110.58 to the U.S. dollar and Yen 137.04 to the euro, representing a year-on-year decrease of almost 2% against both currencies.
Summary of operations
     Canon achieved record highs in both consolidated net sales and net income, and a sixth consecutive year of sales and profit growth, mainly due to a significant increase in sales of digital cameras and color network digital MFDs, along with an increase in sales of projection aligners. In fiscal 2005, Canon achieved 8.3% growth in net sales, to Yen 3,754,191 million, and an 11.9% increase in net income, to Yen 384,096 million. Canon’s gross profit increased by 6.2%, to Yen 1,819,043 million.
Key performance indicators
     Following are the key performance indicators (“KPIs”) that Canon uses in managing its business. The changes from year to year in these KPIs are set forth in the table shown below.
KEY PERFORMANCE INDICATORS
                                         
    2005     2004     2003     2002     2001  
Net sales (Millions of yen)
  ¥  3,754,191     ¥  3,467,853     ¥  3,198,072     ¥  2,940,128     ¥  2,907,573  
Gross profit to net sales ratio
    48.5 %     49.4 %     50.3 %     47.6 %     44.0 %
R&D expense to net sales ratio
    7.6 %     7.9 %     8.1 %     7.9 %     7.5 %
Operating profit to net sales ratio
    15.5 %     15.7 %     14.2 %     11.8 %     9.7 %
Inventory turnover within days
  47 days   49 days   49 days   51 days   57 days
Debt to total assets ratio
    0.8 %     1.1 %     3.1 %     5.0 %     10.4 %
Stockholders’ equity to total assets ratio
    64.4 %     61.6 %     58.6 %     54.1 %     51.3 %
Note: Inventory turnover within days; Inventory divided by net sales for the previous six months, multiplied by 182.5.

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-Revenues-
     As Canon seeks to become a truly excellent global company, one indicator upon which Canon’s management places strong emphasis is revenue. Following are some of the KPIs relating to revenues that management considers to be important.
     Net sales is one such KPI. Canon derives net sales primarily from the sale of products and, to a lesser extent, providing of services relating to its products. Sales vary based on such factors as product demand, the number and size of transactions within the reporting period, product reputation for new products, and changes in sales prices. Other factors involved are market share and market environment. In addition, management considers an evaluation of net sales by product group to be important in assessing Canon’s performance in sales in various product groups in light of market trends.
     Gross profit ratio (ratio of gross profit to net sales) is another KPI for Canon. Through its reforms in product development, Canon has been striving to shorten product development lead times in order to launch new, competitively priced products at a faster pace. In addition, Canon has achieved cost reductions through efficiency enhancements in production. Canon believes that these achievements have contributed to improving Canon’s gross profit ratio, and Canon intends to continue to pursue further shortening of product development lead times and reductions in production costs.
     Operating profit ratio (ratio of operating profit to net sales) and research and development (“R&D”) expense to net sales ratio are considered by Canon to be KPIs. Canon is focusing on two areas for improvement. On the one hand, Canon strives to control and reduce its selling, general and administrative expenses. On the other hand, Canon’s R&D policy is designed to maintain a high level of spending in core technology in order to sustain Canon’s leading position in its current fields of business, and to explore possibilities in other markets. Canon believes such investments will be the basis for future success in its business and operations.
-Cash Flow Management-
     Canon also places significant emphasis on cash flow management. The following are the KPIs relating to cash flow management that management believes to be important.
     Inventory turnover within days is a KPI because it is a measure of supply chain management efficiency. Inventories have inherent risks of becoming obsolete, deteriorating or otherwise decreasing in value significantly, which may adversely affect Canon’s operating results. To mitigate these risks, management believes that it is important to continue reducing inventories and shortening production lead times in order to achieve early recovery of related product expenses by strengthening supply chain management.
     Canon’s management seeks to meet its liquidity and capital requirements primarily with cash flow from operations and also seeks debt-free operations. For a manufacturing company such as Canon, the process for realizing profit on any endeavor can be lengthy, involving as it does R&D, manufacturing and sales activities. Management, therefore, believes that it is important to have sufficient financial strength so that it does not have to rely on external funding. Canon has continued to reduce its reliance on external funding for capital investments in favor of generating the necessary funds from its own operations.
     Stockholders’ equity to total assets ratio (ratio of total stockholder’s equity to total assets) is another KPI for Canon. Canon believes that stockholders’ equity to total assets ratio measures its long-term viability. Canon believes that a high or increasing stockholders’ equity ratio usually indicates that Canon has a good, or improving ability to fund debt obligations and other unexpected expenses, which means in the long-term that Canon is better able to maintain a high level of stable investments for its future operations and development. As Canon puts a strong emphasis on its research and development activities, management believes that it is important to maintain a stable financial base and, accordingly, a high level of stockholders’ equity to total assets ratio.
Critical accounting policies and estimates
     The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, and based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. Canon believes that the following are some of the more critical judgment areas in the application of its accounting policies that currently affect its financial condition and results of operations.
Revenue recognition
     Canon generates revenue principally through the sale of consumer products, equipment, supplies and related services under separate contractual arrangements. Canon recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred and title and risk of loss have been transferred to the customer, the sales price is fixed or determinable, and collectibility is probable.
     For arrangements with multiple elements, which may include any combination of equipment, installation and maintenance, Canon allocates revenue to each element based on its relative fair value if such element meets the criteria for treatment as a separate unit of accounting as prescribed in the Emerging Issues Task Force Issue No.00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” Otherwise, revenue is deferred until the undelivered elements are fulfilled as a single unit of accounting.
     Revenue from sales of consumer products including office imaging products, computer peripherals, business information products and cameras is recognized upon shipment or delivery, depending upon when title and risk of loss transfer to the customer.
     Revenue from sales of optical equipment such as steppers and aligners sold with customer acceptance provisions related to their functionality is recognized when the equipment is installed at the customer site and the specific criteria of the equipment functionality are successfully tested and demonstrated by Canon. Service revenue is derived primarily from maintenance contracts on equipment sold to customers and is recognized over the term of the contract.
     Most office imaging products are sold with service maintenance contracts for which the customer typically pays a base service fee plus a variable amount based on usage. Revenue from these service maintenance contracts is recognized as services are provided.
     Revenue from the sale of equipment under sales-type leases is recognized at the inception of the lease. Income on sales-type leases and direct-financing leases is recognized over the life of each respective lease using the interest method. Leases not qualifying as sales-type leases or direct-financing leases are accounted for as operating leases and related revenue is recognized over the lease term.
     Canon records estimated reductions to sales at the time of sale for sales incentive programs including product discounts, customer promotions and volume-based rebates. Estimated reductions in sales are based upon historical trends and other known factors at the time of sale. In addition, Canon provides price protection to certain resellers of its products, and records reductions to sales for the estimated impact of price protection obligations when announced.
     Estimated product warranty costs are recorded at the time revenue is recognized and is included in selling, general and administrative expenses. Estimates for accrued product warranty costs are based on historical experience, and are affected by ongoing product failure rates, specific product class failures outside of the baseline experience, material usage and service delivery costs incurred in correcting a product failure.

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Allowance for doubtful receivables
     Allowance for doubtful receivables is determined using a combination of factors to ensure that Canon’s trade and financing receivables are not overstated due to uncollectibility. Canon maintains a bad debt reserve for all customers based on a variety of factors, including the length of time receivables are past due, trends in overall weighted average risk rating of the total portfolio, macroeconomic conditions, significant one-time events and historical experience. Also, Canon records specific reserves for individual accounts when Canon becomes aware of a customer’s inability to meet its financial obligations to Canon, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. If circumstances related to customers change, estimates of the recoverability of receivables would be further adjusted.
Valuation of inventories
     Inventories are stated at the lower of cost or market value. Cost is determined principally by the average method for domestic inventories and the first-in, first-out method for overseas inventories. Market value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make a sale. Canon routinely reviews its inventories for their salability and for indications of obsolescence to determine if inventories should be written-down to market value. Judgments and estimates must be made and used in connection with establishing such allowances in any accounting period. In estimating the market value of its inventories, Canon considers the age of the inventories and the likelihood of spoilage or changes in market demand for its inventories.
Environmental liabilities
     Canon is subject to liability for the investigation and clean-up of environmental contamination at each of the properties that Canon owns or operates, as well as at certain properties Canon formerly owned or operated. Canon employs extensive internal environmental protection programs that focus on preventive measures. Canon conducts environmental assessments for a number of its locations and operating facilities. If Canon was to be held responsible for damages in any future litigation or proceedings, such costs may not be covered by insurance and may be material. The liability for environmental remediation and other environmental costs is accrued when it is considered probable and costs can be reasonably estimated.
Valuation of deferred tax assets
     Canon currently has significant deferred tax assets, which are subject to periodic recoverability assessments. Realization of Canon’s deferred tax assets is principally dependent upon its achievement of projected future taxable income. Canon’s judgments regarding future profitability may change due to future market conditions, its ability to continue to successfully execute its operating restructuring activities and other factors. Any changes, in any of these factors may require possible recognition of significant valuation allowance to these deferred tax asset balances. When Canon determines that certain deferred tax assets may not be recoverable, the amounts which will not be realized are charged to income tax expense and will adversely affect net income.
Employee retirement and severance benefit plans
     Canon has significant employee retirement and severance benefit obligations which are recognized based on actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected return on plan assets. Management must consider current market conditions, including changes in interest rates, in selecting these assumptions. Other assumptions include assumed rate of increase in compensation levels, mortality rate and withdrawal rate. Changes in these assumptions inherent in the valuation are reasonably likely to occur from period to period. These changes in assumptions may lead to changes in related employee retirement and severance benefit costs in the future.
     Actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, generally affect future pension expenses. While management believes that the assumptions used are appropriate, the differences may affect employee retirement and severance benefit costs in the future.
     In preparing its financial statements for fiscal 2005, Canon estimated a discount rate of 2.7% and an expected long-term rate of return on plan assets of 4.6%. In estimating the discount rate, Canon uses available information about rates of return on high-quality fixed-income governmental and corporate bonds currently available and expected to be available during the period to the maturity of the pension benefits. Canon establishes the expected long-term rate of return on plan assets based on management’s expectations of the long-term return of the various plan asset categories in which it invests. Management develops expectations with respect to each plan asset category based on actual historical returns and its current expectations for future returns.
     Decreases in discount rates lead to increases in actuarial pension benefit obligations which, in turn, could lead to an increase in service cost and amortization cost through amortization of actuarial gain or loss, a decrease in interest cost and vice versa. A decrease of 50 basis points in the discount rate increases the projected benefit obligation by approximately 11%. The net effect of changes in the discount rate, as well as the net effect of other changes in actuarial assumptions and experience, are deferred until subsequent periods, as permitted by the Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions.”
     Decrease in expected return on plan assets may increase net periodic benefit cost by decreasing expected return amounts, while differences between expected value and actual fair value of those assets could affect pension expense in the following years, and vice versa. For fiscal 2006, if a change of 50 basis points in the expected long-term rate of return on plan assets is to occur, that may cause a change of approximately Yen 2,730 million in net periodic benefit cost. Canon multiplies management’s expected long-term rate of return on plan assets by the value of its plan assets, to arrive at the expected return on plan assets that is included in pension income (expense). Canon defers recognition of the difference between this expected return on plan assets and the actual return on plan assets. The net deferral of unrecognized actuarial gains (losses) affects the value of plan assets in future fiscal years and, ultimately, future pension income (expense).

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Consolidated result of operations
Fiscal 2005 compared with fiscal 2004
     Summarized results of operations for fiscal 2005 and fiscal 2004 are as follows:
                         
    2005     Change     2004  
    (Millions of yen, except per share  
    amounts and percentage data)  
Net sales
  ¥  3,754,191       +8.3 %   ¥  3,467,853  
Operating profit
    583,043       +7.2       543,793  
Income before income taxes and minority interests
    612,004       +10.8       552,116  
Net income
    384,096       +11.9       343,344  
 
                       
Net income per share:
                       
Basic
    432.94       +11.6       387.80  
Diluted
    432.55       +11.8       386.78  
Note: See note of Item 3A “Selected Financial Data.”
Sales
     Canon’s consolidated net sales in fiscal 2005 totaled Yen 3,754,191 million. This represents an 8.3% increase from the previous fiscal year, reflecting significant growth in sales of digital cameras, color network digital MFDs and projection aligners.
     Overseas operations are significant to Canon’s operating results and generated approximately 74% of total net sales in fiscal 2005. Such sales are denominated in the applicable local currency and are subject to fluctuations in the value of the yen in relation to such other currencies. Despite efforts to reduce the impact of currency fluctuations on operating results, including localizing some manufacturing and procuring parts and materials from overseas suppliers, Canon believes such fluctuations have had and will continue to have a significant effect on results of operations.
     The average value of the yen in fiscal 2005 was Yen 110.58 to the U.S. dollar, and Yen 137.04 to the euro, representing a depreciation of 2% against both currencies, compared with the previous year. These effects of foreign exchange rate fluctuations favorably impacted net sales by approximately Yen 66,400 million. Net sales denominated in foreign currency increased by approximately Yen 41,500 million in U.S. dollars, increased by Yen 16,300 million in euro, and increased by Yen 8,600 million in other foreign currencies.
Cost of sales
     Cost of sales principally reflects the cost of raw materials, parts and labor used by Canon in the manufacture of its products. A portion of the raw materials used by Canon is imported or includes imported materials. Such raw materials are subject to fluctuations in world market prices and exchange rates that may affect Canon’s cost of sales. Other components of cost of sales include depreciation expenses from plants, maintenance expenses, light and fuel expenses and rent expenses. The ratio of cost of sales to net sales for fiscal 2005, 2004 and 2003 was 51.5%, 50.6% and 49.7%, respectively.
Gross profit
     Canon’s gross profit in fiscal 2005 increased by 6.2% to Yen 1,819,043 million from fiscal 2004. Despite such negative factors as escalating prices of raw materials and a severe price competition, gross profit ratio for the year remained at high, with a decrease of 0.9 points from the previous year, owing to cost reductions realized through ongoing production-reform and procurement-reform efforts.
Selling, general and administrative expenses and research and development expenses
     The major components of selling, general and administrative expenses are payroll, R&D, advertising expenses and other marketing expenses. Although R&D expenses grew 4.1% from the previous year to Yen 286,476 million, keeping spending growth below the growth rate for net sales, the selling, general and administrative expenses to net sales ratio improved 0.7 points. In general, Canon maintains a high level of R&D expenditure to strengthen its R&D capabilities. R&D expenditures grew in fiscal 2005 from the previous year, resulting from increased R&D activities.
Operating profit
     Operating profit in fiscal 2005 increased by 7.2% to Yen 583,043 million from fiscal 2004. Operating profit in fiscal 2005 was 15.5% of net sales, compared with 15.7% in fiscal 2004.
Other income (deductions)
     Other income (deductions) improved by Yen 20,638 million, attributable to an increase of interest revenue, resulting from such factors as an increase in surplus funds accompanying the improved balance sheet and a rise in interest rates in the United States, along with a decrease in currency exchange losses.
Income before income taxes and minority interests
     Income before income taxes and minority interests in fiscal 2005 was Yen 612,004 million, a 10.8% increase from fiscal 2004, and constituted 16.3% of net sales.

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Income taxes
     Provision for income taxes increased by Yen 18,771 million from fiscal 2004, primarily as a result of the increase in income before income taxes and minority interests. The effective tax rate during fiscal 2005 declined by 0.3% compared with fiscal 2004.
Net income
     Net income in fiscal 2005 increased by 11.9% to Yen 384,096 million, which exceeds the growth rate of income before income taxes and minority interests. This represents a 10.2% return on net sales.
Product information
     Canon divides its businesses into three product groups: business machines, cameras and optical and other products.
    The business machines product group includes office imaging products, computer peripherals and business information products.
    Office imaging products include office network digital MFDs, color network digital MFDs, office copying machines, personal-use copying machines and full-color copying machines.
    Computer peripherals include laser beam printers, inkjet printers, inkjet multifunction peripherals and image scanners.
    Business information products include micrographic equipment, personal computers and calculators.
    The cameras product group includes SLR cameras, compact cameras, digital cameras and digital video camcorders.
    The optical and other products product group includes steppers for semiconductor chip production, mirror projection mask aligners used in the production of LCDs, television broadcasting lenses and medical equipment.
     Effective January 2004, Canon has changed classification of product categories with regards to information system business, which had been classified in “Optical and other products,” to “Business machines (Office imaging products)” in order to better reflect the current relation with those products. Accordingly, information for previous fiscal years has been reclassified to conform with the current classification.
Sales by product
     Canon’s sales by product group are summarized as follows:
                         
    2005     Change     2004  
    (Millions of yen, except percentage data)  
Business machines:
                       
      Office imaging products
  ¥  1,153,240       +2.9 %   ¥  1,120,972  
      Computer peripherals
    1,244,906       +8.3       1,149,914  
      Business information products
    104,255       -10.9       117,067  
 
                 
Total business machines
    2,502,401       +4.8       2,387,953  
 
                 
Cameras
    879,186       +15.2       763,079  
Optical and other products
    372,604       +17.6       316,821  
 
                 
       Total
  ¥  3,754,191       +8.3 %   ¥  3,467,853  
 
                 
     Sales of business machines, constituting 66.7% of consolidated net sales, increased 4.8%, to Yen 2,502,401 million in fiscal 2005.
     Sales of office imaging products increased 2.9%, to Yen 1,153,240 million. Demand for network digital MFDs continues to shift from monochrome machines to color models, as well as towards higher-end features. The Color imagingRunner(“iR”) C3170/2570 series, equipped with a new high-speed image-processing chip, and the iR C3220/2620 series continued to sell well in both Japan and European markets, as did the new high-speed iR C6870/5870 series models. Among monochrome network digital MFDs, mid-level models such as the iR4570/3570/2870/2270 series contributed to expanded sales, along with the iR6570/5570, featuring energy-saving performance and high productivity, and the iR2020/2016 series, with enhanced networking features. Color office imaging products accounted for 28% and 24% and monochrome office imaging products accounted for 56% and 62% of office imaging products sales in fiscal 2005 and 2004, respectively. Sales of facsimiles and information system business accounted for 16% and 14% of sales of office imaging products in both fiscal 2005 and 2004, respectively.
     Sales of computer peripherals increased 8.3% to Yen 1,244,906 million. Laser beam printers enjoyed a year-on-year increase in unit sales, with color models growing more than 30% and monochrome machines, particularly low-end models, also recording healthy growth. Sales in value terms also rose despite the effect of the shift in market demand toward lower priced models. Inkjet printers recorded an increase in unit sales of more than 10%, with the PIXMA iP3000/4000 and, in markets outside of Japan, the PIXMA MP110/130 maintaining brisk sales. Additionally, newly introduced models, including the PIXMA iP4200, the PIXMA iP1600 in overseas markets, and high-speed all-in-one models such as the PIXMA MP500, contributed to a stronger product lineup, which also fueled sales growth in value terms.
     Sales of business information products decreased 10.9%, to Yen 104,255 million in fiscal 2005, mainly due to the intentional curtailing of personal computer sales in the domestic market.

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     Sales of cameras continued to achieve significant sales growth of 15.2%, totaling Yen 879,186 million. The continued strong demand for digital SLR cameras has fueled robust growth, with the EOS DIGITAL REBEL XT, launched in the first half of 2005, and the EOS 5D, launched in the second half, recording particularly strong sales along with continued healthy sales of the EOS 20D, launched in the previous period. This, in turn, has led to expanded sales of interchangeable lenses for SLR cameras. Sales of compact-model digital cameras also continued to expand steadily, with healthy demand for the PowerShot SD400 and PowerShot A520, launched in the first half of 2005, as well as the PowerShot SD550 and PowerShot SD450 models, introduced in the second half. As a result, unit sales of digital cameras grew by more than 20% compared with the previous year. Digital cameras accounted for 72% and 69% and conventional film cameras accounted for 17% and 16% of camera sales in fiscal 2005 and 2004, respectively. In the field of digital video camcorders, newly introduced Mini DV, DVD, and HDV models, including the Optura 600, the DC20/10, and the XL H1 registered strong performances. Video camcorders accounted for the remaining 11% and 15% of camera sales in fiscal 2005 and 2004, respectively. Sales of cameras constituted 23.4% of consolidated net sales in fiscal 2005.
     Sales of optical and other products increased 17.6%, to Yen 372,604 million. In the optical and other products segment, demand for steppers, used in the production of semiconductors, has continued to lag since the summer of 2004, resulting in a drop in the number of units sold and, consequently, a decrease in sales value. Sales of aligners, however, which are used in the production of LCD panels realized notable growth in terms of both volume and value owing to increased investments by LCD manufacturers in response to the rapidly expanding LCD television market. Additionally, the vacuum thin-film deposition and processing equipment produced by the Company’s newly consolidated subsidiaries contributed to expanded sales. Sales of optical and other products constituted 9.9% of consolidated net sales in fiscal 2005.
Sales by region
     A summary of net sales by region in fiscal 2005 and fiscal 2004 is provided below:
                         
    2005     Change     2004  
    (Millions of yen, except percentage data)  
Japan
  ¥  856,205       +0.8 %   ¥  849,734  
Americas
    1,145,950       +8.2       1,059,425  
Europe
    1,181,258       +8.0       1,093,295  
Others
    570,778       +22.6       465,399  
 
                 
Total
  ¥  3,754,191       +8.3 %   ¥  3,467,853  
 
                 
Note: This summary of net sales by region of destination is determined by the location of the customer.  
     A geographical analysis indicates that net sales in fiscal 2005 increased in every region.
     In Japan, net sales increased by 0.8% in fiscal 2005 from fiscal 2004. The results were mainly attributable to increased sales of office imaging products, computer peripherals, and digital cameras. Color network digital MFDs which include the Color imageRUNNER(“iR”) C3170/2570 series, equipped with a new high-speed image-processing chip, and the iR C3220/2620 series lineup, have contributed to increased sales of office imaging products.
     In the Americas, net sales increased by 5.7% on a local currency basis, mainly due to increased sales of digital cameras, and laser beam printers. Sales of digital cameras experienced continued strong demand and benefited from the effect of newly-launched products such as PowerShot-series models and Canon’s digital SLR. On a yen basis, after accounting for the appreciation of the yen against the U.S. dollar, net sales in the Americas increased by 8.2%.
     In Europe, net sales increased by 6.1% on a local currency basis mainly due to increased sales of digital cameras and laser beam printers. On a yen basis, after accounting for the depreciation of the yen against the euro, net sales in Europe grew 8.0% in fiscal 2005.
     Sales in other areas increased by 22.6% on a yen basis in fiscal 2005, reflecting overall sales growth, particularly in digital cameras and semiconductor equipment.
Operating profit by product
     Operating profit for business machines in fiscal 2005 increased Yen 20,944 million to Yen 542,028 million. The gross profit ratio remained at a previous year level, due to cost reduction efforts, and the sales-to-expense ratio declined, contributing to an increase in operating profit.
     Operating profit for cameras increased Yen 42,908 million to Yen 173,706 million. The gross profit ratio improved, due to an increase in unit sales of digital cameras.
     Optical and other products in fiscal 2005 increased Yen 9,988 million to Yen 38,820 million. The gross profit ratio increased compared to the previous year, due to an increase in sales of aligners.

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Fiscal 2004 compared with fiscal 2003
     Summarized results of operations for fiscal 2004 and fiscal 2003 are as follows:
                         
    2004     Change     2003  
    (Millions of yen, except per share  
    amounts and percentage data)  
Net sales
  ¥ 3,467,853       +8.4 %   ¥ 3,198,072  
Operating profit
    543,793       +19.7       454,424  
Income before income taxes and minority interests
    552,116       +23.2       448,170  
Net income
    343,344       +24.5       275,730  
 
                       
Net income per share:
                       
Basic
    387.80       +23.6       313.81  
Diluted
    386.78       +24.5       310.75  
Note: See note of Item 3A “Selected Financial Data.”
Sales
     Canon’s consolidated net sales in fiscal 2004 totaled Yen 3,467,853 million. This represents an 8.4% increase from the previous fiscal year, reflecting significant growth in sales of digital cameras, color network digital MFDs and semiconductor-production equipment.
     Overseas operations are significant to Canon’s operating results and generated approximately 73% of total net sales in fiscal 2004. Such sales are denominated in the applicable local currency and are subject to fluctuations in the value of the yen in relation to such other currencies. Despite efforts to reduce the impact of currency fluctuations on operating results, including localizing some manufacturing and procuring parts and materials from overseas suppliers, Canon believes such fluctuations have had and will continue to have a significant effect on results of operations.
     The average value of the yen in fiscal 2004 was Yen 108.12 to the U.S. dollar, and Yen 134.57 to the euro, representing an appreciation of 7% against the U.S. dollar, and a depreciation of 3% against the euro, compared with the previous year. These effects of foreign exchange rate fluctuations unfavorably impacted net sales by approximately Yen 57,000 million. Net sales denominated in foreign currency decreased by approximately Yen 77,700 million in U.S. dollars, increased by Yen 20,300 million in euro, and increased by Yen 400 million in other foreign currencies.
Cost of sales
     Cost of sales principally reflects the cost of raw materials, parts and labor used by Canon in the manufacture of its products. A portion of the raw materials used by Canon is imported or includes imported materials. Such raw materials are subject to fluctuations in world market prices and exchange rates that may affect Canon’s cost of sales. Other components of cost of sales include depreciation expenses from plants, maintenance expenses, light and fuel expenses and rent expenses. The ratio of cost of sales to net sales for fiscal 2004 and 2003 was 50.6% and 49.7%, respectively.
Gross profit
     Canon’s gross profit in fiscal 2004 increased by 6.5% to Yen 1,713,343 million from fiscal 2003. Despite ongoing efficiency enhancements in production during fiscal 2004 and the timely launch of competitive new products, the gross profit ratio decreased 0.9% from the previous year to 49.4%, mainly due to severe price competition and the appreciation of the yen against the U.S. dollar.
Selling, general and administrative expenses and research and development expenses
     The major components of selling, general and administrative expenses are payroll, R&D, advertising expenses and other marketing expenses. Selling, general and administrative expenses in fiscal 2004 increased by 1.3%, as compared with fiscal 2003, to Yen 1,169,550 million in fiscal 2004. This increase primarily reflects an increase in R&D expenditures by 6.2% to Yen 275,300 million, reflecting management’s policy to maintain a high level of R&D expenditure to strengthen Canon’s R&D capabilities and an increase in advertising and other marketing expense by 11.5% to Yen 111,770 million, reflecting management’s policy to strengthen Canon’s corporate and brand image. This increase was partially offset by a decrease in other selling, general and administrative expenses and a Yen 17,141 million gain realized from the return to the Japanese Government of a portion of the Employees’ Pension Funds (EPF) of the Company and certain of its subsidiaries in Japan.
Operating profit
     Operating profit in fiscal 2004 increased by 19.7% to Yen 543,793 million from fiscal 2003. Operating profit in fiscal 2004 was 15.7% of net sales, compared with 14.2% in fiscal 2003.
Other income (deductions)
     Other income (deductions) improved by Yen 14,577 million, attributable to gains from sales of stock of subsidiary companies’ shares which totaled Yen 9,082 million, along with a decrease in currency exchange losses and improved equity gains (losses) of affiliated companies.
Income before income taxes and minority interests
     Income before income taxes and minority interests in fiscal 2004 was Yen 552,116 million, a 23.2% increase from fiscal 2003, and constituted 15.9% of net sales.

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Income taxes
     Provision for income taxes increased by Yen 31,361 million from fiscal 2003, primarily as a result of the increase in income before income taxes and minority interests. The effective tax rate during fiscal 2004 declined by 1.2% compared with fiscal 2003.
Net income
     Net income in fiscal 2004 increased by 24.5% to Yen 343,344 million, which exceeds the growth rate of income before income taxes and minority interests due primarily the decrease in the effective tax rate during the period. This represents a 9.9% return on net sales.
Product information
     On a consolidated basis, Canon divides its businesses into three product groups: business machines, cameras and optical and other products.
    The business machines product group includes office imaging products, computer peripherals and business information products.
    Office imaging products include office network digital MFDs, color network digital MFDs, office copying machines, personal-use copying machines and full-color copying machines.
    Computer peripherals include laser beam printers, inkjet printers, inkjet multifunction peripherals and image scanners.
    Business information products include micrographic equipment, personal computers and calculators.
    The cameras product group includes single lens reflex (“SLR”) cameras, compact cameras, digital cameras and digital video camcorders.
    The optical and other products product group includes steppers for semiconductor chip production, mirror projection mask aligners used in the production of LCDs, television broadcasting lenses and medical equipment.
     Effective January 2004, Canon has changed the classification of its information system business. The information system business which had been included in “Optical and other products”, was reclassified as “Business machines (Office imaging products)” in order to better reflect its relation with the other products of the business machines group. Accordingly, information for previous fiscal years has been reclassified to conform with the current classification.
Sales by product
     Canon’s sales by product group are summarized as follows:
                         
    2004     Change     2003  
    (Millions of yen, except percentage data)  
Business machines:
                       
Office imaging products
  ¥  1,120,972       +3.6 %   ¥  1,081,995  
Computer peripherals
    1,149,914       +5.6       1,089,312  
Business information products
    117,067       -5.2       123,493  
 
                 
Total business machines
    2,387,953       +4.1       2,294,800  
 
                 
Cameras
    763,079       +16.8       653,540  
Optical and other products
    316,821       +26.9       249,732  
 
                 
Total
  ¥ 3,467,853       +8.4 %   ¥ 3,198,072  
 
                 
     Sales of business machines, constituting 69% of consolidated net sales, increased 4.1%, to Yen 2,387,953 million in fiscal 2004.
     Sales of office imaging products increased 3.6%, to Yen 1,120,972 million. Demand for network digital MFDs continues to shift from monochrome machines to color models, as well as towards higher-end features. The Color imageRUNNER(iR) C3200/iRC3200N recorded strong sales in both the domestic Japanese and overseas markets. The iRC3100 and the high end model iRC6800, introduced in Japan in the second half of fiscal 2003, were also launched in Europe and the United States in the first half of fiscal 2004 and have also recorded strong sales. The iRC3220/iRC3220N, which succeeds the iRC3200, and the iRC2620/iRC2620N were launched in September 2004 and have also recorded strong sales. Among monochrome network digital MFDs, such low-end models as the iR1600/2000 series recorded considerable sales increases, while mid-level models, such as the iR2200 series, and high-end models, such as the iR5000 series, also achieved strong sales. Color office imaging products accounted for 24% and 20% and monochrome office imaging products accounted for 62% and 67% of office imaging products sales in fiscal 2004 and 2003, respectively. Sales of facsimiles and information system business accounted for 14% and 13% of sales of office imaging products in both fiscal 2004 and 2003.
     Sales of computer peripherals increased 5.6% to Yen 1,149,914 million. Despite the effects of the yen’s appreciation against the U.S. dollar and a shift in demand toward lower priced models in the monochrome and color segment, laser beam printer sales substantially increased due to an increase in sales of color models. Inkjet printers recorded an approximately 20% increase in unit sales, primarily as a result of sales of the PIXMA iP3100 and iP4100 models, especially in Japan and Europe, and the PIXMA MP700 and MultiPASS MP370 high-speed multifunction systems. The adverse effect of severe price competition on sales of computer peripherals was more than offset by a rise in unit sales.
     Sales of business information products decreased 5.2%, to Yen 117,067 million in fiscal 2004, mainly due to the intentional curtailing of personal computer sales in the domestic market.

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     Sales of cameras continued to achieve significant sales growth of 16.8%, totaling Yen 763,079 million. Amid the continued strong demand for digital models worldwide, sales of compact digital cameras showed significant growth, boosted by the launch of eight new PowerShot-series models for fiscal 2004, including the PowerShot S500 Digital ELPH and PowerShot A75. Canon’s digital SLR cameras also continued to enjoy robust growth, bolstered by strong sales of the EOS Digital Rebel, and the EOS 20D which is successor of the EOS 10D. As a result, unit sales of digital cameras grew by nearly 60% compared with the previous year. Digital cameras accounted for 69% and 61% and conventional film cameras accounted for 16% and 21% of camera sales in fiscal 2004 and 2003, respectively. Video camcorders accounted for the remaining 15% and 18% of camera sales in fiscal 2004 and 2003, respectively. In the field of digital video camcorders, new models such as the Optura 500/400, Elura 70/65/60 and Optura 40/30 achieved favorable sales during fiscal 2004. Sales of cameras constituted 22% of consolidated net sales in fiscal 2004, an increase of 2% from fiscal 2003, primarily due to increased sales of digital cameras.
     Sales of optical and other products increased by 26.9%, to Yen 316,821 million. Sales of aligners for the production of LCDs realized notable growth as the PC monitor industry continued to shift from cathode-ray tube (CRT) to LCD computer displays, and the LCD television market continued to expand. Sales of steppers, used for the production of semiconductors, also increased as investment in semiconductor-production equipment showed a recovery owing to the improved conditions in the semiconductor-device market. Sales of optical and other products constituted 9% of consolidated net sales in fiscal 2004, an increase of 1% from fiscal 2003, primarily due to increased sales of aligners for LCDs and steppers.
Sales by region
     A summary of net sales by region in fiscal 2004 and fiscal 2003 is provided below:
                         
    2004     Change     2003  
    (Millions of yen, except percentage data)  
Japan
  ¥ 849,734       +6.0 %   ¥ 801,400  
Americas
    1,059,425       +1.4       1,045,166  
Europe
    1,093,295       +12.8       969,042  
Others
    465,399       +21.7       382,464  
 
                 
Total
  ¥  3,467,853       +8.4 %   ¥  3,198,072  
 
                 
Note: This summary of net sales by region of destination is determined by the location of the customer.
     A geographical analysis indicates that net sales in fiscal 2004 increased in every region.
     In Japan, net sales increased by 6.0% in fiscal 2004 from fiscal 2003. The results were mainly attributable to increased sales of office imaging products and digital cameras. Color network digital MFDs, which include the Color imageRUNNER(“iR”) C3200/iRC3200N, Canon’s first color offering in the powerful imageRUNNER-series lineup, have contributed to increased sales of office imaging products.
     In the Americas, net sales increased by 8.3% on a local currency basis, mainly due to increased sales of digital cameras, and laser beam printers. Sales of digital cameras experienced continued strong demand and benefited from the effect of newly-launched products such as PowerShot-series models and Canon’s digital SLR. On a yen basis, after accounting for the appreciation of the yen against the U.S. dollar, net sales in the Americas increased by 1.4%.
     In Europe, net sales increased by 11.6% on a local currency basis mainly due to increased sales of digital cameras, Color network digital MFDs and laser beam printers. On a yen basis, after accounting for the depreciation of the yen against the euro, net sales in Europe grew 12.8% in fiscal 2004.
     Sales in other areas increased by 21.7% on a yen basis in fiscal 2004, reflecting overall sales growth, particularly in digital cameras and semiconductor equipment.
Operating profit by product
     Operating profit for business machines in fiscal 2004 increased Yen 35,519 million to Yen 521,084 million. Despite the effects of the stronger yen, the gross profit ratio (ratio of gross profit to net sales) remained at prior year levels, due to cost reduction efforts, and the sales-to-expense ratio declined, contributing to an increase in operating profit.
     Operating profit for cameras increased Yen 4,480 million to Yen 130,798 million. Despite the negative effects of the stronger yen and price competition, along with the impact of increased advertising and sales-promotion spending, an increase in unit sales of digital cameras contributed to improved profitability.
     Optical and other products generated operating profits of Yen 28,832 million in fiscal 2004, as compared to losses of Yen 9,883 million in fiscal 2003, due to a significant increase in sales of aligners and steppers.

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Segment information by product and geographic area
     Segment information by product and by geographic area for the years ended December 31, 2005, 2004 and 2003 are shown below.
The following table provides segment information by product:
                                         
    As of/for the year ended December 31, 2005  
                    Optical              
    Business             and other     Corporate and        
    machines     Cameras     products     Eliminations     Consolidated  
    (Millions of yen)  
Net sales:
                                       
Unaffiliated customers
  ¥  2,502,401     ¥  879,186     ¥  372,604           ¥  3,754,191  
Intersegment
                158,114     ¥ (158,114 )      
 
                             
Total
    2,502,401       879,186       530,718       (158,114 )     3,754,191  
 
                             
Operating cost and expenses
    1,960,373       705,480       491,898       13,397       3,171,148  
 
                             
Operating profit
  ¥ 542,028     ¥ 173,706     ¥ 38,820     ¥ (171,511 )   ¥ 583,043  
 
                             
Assets
  ¥ 1,427,277     ¥ 480,957     ¥ 517,527     ¥ 1,617,792     ¥ 4,043,553  
Depreciation and amortization
    123,037       27,662       28,011       47,231       225,941  
Capital expenditure
    201,887       57,678       15,955       108,264       383,784  
                                         
    As of/for the year ended December 31, 2004  
                    Optical              
    Business             and other     Corporate and        
    machines     Cameras     products     Eliminations     Consolidated  
    (Millions of yen)  
Net sales:
                                       
Unaffiliated customers
  ¥  2,387,953     ¥  763,079     ¥  316,821           ¥  3,467,853  
Intersegment
                138,419     ¥ (138,419 )      
 
                             
Total
    2,387,953       763,079       455,240       (138,419 )     3,467,853  
 
                             
Operating cost and expenses
    1,866,869       632,281       426,408       (1,498 )     2,924,060  
 
                             
Operating profit
  ¥ 521,084     ¥ 130,798     ¥ 28,832     ¥ (136,921 )   ¥ 543,793  
 
                             
Assets
  ¥ 1,338,817     ¥ 399,207     ¥ 418,418     ¥ 1,430,579     ¥ 3,587,021  
Depreciation and amortization
    115,830       21,880       24,895       30,087       192,692  
Capital expenditure
    134,128       39,783       52,264       92,555       318,730  
                                         
    As of/for the year ended December 31, 2003  
                    Optical              
    Business             and other     Corporate and        
    machines     Cameras     products     Eliminations     Consolidated  
    (Millions of yen)  
Net sales:
                                       
Unaffiliated customers
  ¥  2,294,800     ¥  653,540     ¥  249,732           ¥  3,198,072  
Intersegment
                132,389     ¥ (132,389 )      
 
                             
Total
    2,294,800       653,540       382,121       (132,389 )     3,198,072  
 
                             
Operating cost and expenses
    1,809,235       527,222       392,004       15,187       2,743,648  
 
                             
Operating profit
  ¥ 485,565     ¥ 126,318     ¥ (9,883 )   ¥ (147,576 )   ¥ 454,424  
 
                             
Assets
  ¥ 1,266,881     ¥ 317,672     ¥ 412,117     ¥ 1,185,478     ¥ 3,182,148  
Depreciation and amortization
    118,806       17,712       20,276       26,810       183,604  
Capital expenditure
    106,013       25,894       31,170       46,961       210,038  

Notes:
(1)   General corporate expenses of Yen 171,522 million, Yen 136,929 million and Yen 147,616 million in the years ended December 31, 2005, 2004 and 2003, respectively, are included in “Corporate and Eliminations.” For the fiscal year ended December 31, 2004, a gain of Yen 17,141 million is also included, which relates to the Transfer to the Japanese Government of the Substitutional Portion of Employee Pension Fund Liabilities.
(2)   Corporate assets of Yen 1,239,255 million, Yen 1,430,599 million and Yen 1,185,506 million as of December 31, 2005, 2004 and 2003, respectively, which mainly consist of cash and cash equivalents, marketable securities, investments and corporate properties, are included in “Corporate and Eliminations.”
(3)   The segments are defined under Japanese GAAP. In grouping of segment information by product, Japanese GAAP requires that consideration be given to similarities of product types and characteristics, manufacturing methods, sales markets, and other factors that are similar.

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The following table provides segment information by geographic area:
                                                 
    As of/for the year ended December 31, 2005  
                                    Corporate and        
    Japan     Americas     Europe     Others     Eliminations     Consolidated  
    (Millions of yen)  
Net sales:
                                               
Unaffiliated customers
  ¥ 979,748     ¥ 1,139,784     ¥ 1,178,672     ¥ 455,987           ¥ 3,754,191  
Intersegment
    2,046,173       7,424       2,206       646,530     ¥ (2,702,333 )      
 
                                   
Total
     3,025,921        1,147,208        1,180,878        1,102,517        (2,702,333 )      3,754,191  
Operating cost and expenses
    2,362,019       1,110,415       1,147,658       1,071,155       (2,520,099 )     3,171,148  
 
                                   
Operating profit
  ¥ 663,902     ¥ 36,793     ¥ 33,220     ¥ 31,362     ¥ (182,234 )   ¥ 583,043  
 
                                   
Assets
  ¥ 2,419,012     ¥ 406,101     ¥ 569,750     ¥ 312,472     ¥ 336,218     ¥ 4,043,553  
                                                 
    As of/for the year ended December 31, 2004  
                                    Corporate and        
    Japan     Americas     Europe     Others     Eliminations     Consolidated  
    (Millions of yen)  
Net sales:
                                               
Unaffiliated customers
  ¥ 919,153     ¥ 1,057,066     ¥ 1,090,712     ¥ 400,922           ¥ 3,467,853  
Intersegment
    1,882,973       8,863       4,161       591,677     ¥ (2,487,674 )      
 
                                   
Total
     2,802,126        1,065,929        1,094,873        992,599        (2,487,674 )      3,467,853  
Operating cost and expenses
    2,206,141       1,025,628       1,071,552       965,080       (2,344,341 )     2,924,060  
 
                                   
Operating profit
  ¥ 595,985     ¥ 40,301     ¥ 23,321     ¥ 27,519     ¥ (143,333 )   ¥ 543,793  
 
                                   
Assets
  ¥ 1,793,679     ¥ 341,616     ¥ 533,865     ¥ 271,566     ¥ 646,295     ¥ 3,587,021  
                                                 
    As of/for the year ended December 31, 2003  
                                    Corporate and        
    Japan     Americas     Europe     Others     Eliminations     Consolidated  
    (Millions of yen)  
Net sales:
                                               
Unaffiliated customers
  ¥ 856,851     ¥ 1,044,998     ¥ 968,938     ¥ 327,285           ¥ 3,198,072  
Intersegment
    1,662,172       8,101       3,861       503,119     ¥ (2,177,253 )      
 
                                   
Total
     2,519,023        1,053,099        972,799        830,404        (2,177,253 )      3,198,072  
Operating cost and expenses
    2,025,442       998,492       946,282       806,281       (2,032,849 )     2,743,648  
 
                                   
Operating profit
  ¥ 493,581     ¥ 54,607     ¥ 26,517     ¥ 24,123     ¥ (144,404 )   ¥ 454,424  
 
                                   
Assets
  ¥ 1,600,726     ¥ 306,140     ¥ 546,625     ¥ 249,755     ¥ 478,902     ¥ 3,182,148  

Notes:

(1)   General corporate expenses of Yen 171,522 million, Yen 136,929 million and Yen 147,616 million in the years ended December 31, 2005, 2004 and 2003, respectively, are included in “Corporate and Eliminations.” For the fiscal year ended December 31, 2004, a gain of Yen 17,141 million is also included, which relates to the Transfer to the Japanese Government of the Substitutional Portion of Employee Pension Fund Liabilities.
(2)   Corporate assets of Yen 1,239,255 million, Yen 1,430,599 million and Yen 1,185,506 million as of December 31, 2005, 2004 and 2003, respectively, which mainly consist of cash and cash equivalents, marketable securities, investments and corporate properties, are included in “Corporate and Eliminations.”
(3)   Segment information by geographic area is determined by the location of the Company or its relevant subsidiary making the sale. The segments are defined under Japanese GAAP. In grouping of segment information by geographic area, Japanese GAAP requires that consideration be given to geographic proximity, as well as similarities of economic activities, interrelationships of business activities and other similar factors.

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     Foreign operations and foreign currency transactions
     Canon’s marketing activities are performed by subsidiaries in various regions in local currencies, while the cost of sales is generally in yen. Given Canon’s current operating structure, appreciation of the yen has a negative impact on net sales and the gross profit ratio. To reduce the financial risks from changes in foreign exchange rates, Canon utilizes derivative financial instruments, which are comprised principally of forward currency exchange contracts.
     The return on foreign operation sales is usually lower than that from domestic operations because foreign operations consist mainly of marketing activities. Return on foreign operation sales is calculated by dividing net income of foreign subsidiaries, after factoring in consolidation adjustments between foreign subsidiaries, by net sales of foreign subsidiaries. Marketing activities are generally less profitable than production activities, which are mainly conducted by the Company and its domestic subsidiaries. The returns on foreign operation sales in fiscal 2005, 2004 and 2003 were 3.0%, 2.8% and 3.2%, respectively. This compares with returns of 10.2%, 9.9% and 8.6% on total operations for the respective years.
     Recent developments
     Canon acquired all of the issued and outstanding shares of ANELVA Corporation, which possesses advanced vacuum technology, and made it into a subsidiary as of September 30, 2005. ANELVA Corporation’s corporate name was changed to Canon ANELVA Corporation as of October 1, 2005. By making Canon ANELVA Corporation a subsidiary of the Company, Canon aims to promote the in-house production of manufacturing equipment which Canon believes is indispensable to differentiate Canon products from products of its competitors in various fields, including Canon’s new display business.
     Canon acquired the shares of NEC Machinery Corporation (listed on the Second Section of the Osaka Securities Exchange), which possesses advanced automation technologies, through a tender offer and made it into a subsidiary as of October 19, 2005. NEC Machinery Corporation’s corporate name was changed to Canon Machinery Inc. as of December 17, 2005. By making Canon Machinery Inc. a subsidiary of the Company, Canon aims to make further advance in its production reform activities, including the automation of production processes for Canon products.
     B. Liquidity and capital resources
     Cash and cash equivalents in fiscal 2005 increased Yen 117,179 million to Yen 1,004,953 million, compared with Yen 887,774 million in fiscal 2004 and Yen 690,298 million in fiscal 2003. Canon’s cash and cash equivalents are typically denominated in Japanese yen, with the remainder denominated in foreign currencies such as the U.S. dollar.
     Net cash provided by operating activities in fiscal 2005 increased by Yen 44,149 million from the previous year to Yen 605,678 million, reflecting the substantial growth in sales and increased cash proceeds from sales, combined with a substantial increase in net income and an improvement in working capital. Cash flow from operating activities consisted of the following components: the major component of Canon’s cash inflow is cash received from customers, while the major components of Canon’s cash outflow are payments for parts and materials, selling, general and administrative expenses, and income taxes.
     For fiscal 2005, cash inflow from cash received from customers increased, due to the increase in net sales. This increase in cash inflow was within the range of the increase in net sales, as there were no significant changes in Canon’s collection rates. Cash outflow for payments for parts and materials also increased, as a result of an increase in net sales. However, this increase was less than the increase in net sales, due to the effects of cost reduction. Cost reduction reflects a decline in unit prices of parts and raw materials, as well as a streamlining of the process of using these parts and materials through promoting efficiency in operations. Cash outflow for payroll payments increased, due to the increase in the number of employees. The employees in the Asian region increased, due to the expansion of production in the regions. Cash outflow for payments for selling, general and administrative expenses increased, but the increase was within the range of the increase in net sales, due to cost-cutting efforts. Cash outflow for payments of income taxes increased, due to the increase in taxable income.
     Net cash used in investing activities in fiscal 2005 was Yen 401,141 million, compared with Yen 252,967 million in fiscal 2004 and Yen 199,948 million in fiscal 2003, consisting primarily of capital expenditures. Capital expenditures in fiscal 2005 totaled Yen 383,784 million, which was used mainly to expand production capabilities in Japan and overseas regions and to strengthen the Company’s R&D-related infrastructure. As a result, free cash flow, or cash flow from operating activities minus cash flow from investing activities, totaled Yen 204,537 million for fiscal 2005 as compared to Yen 308,562 million for fiscal 2004.
     Net cash used in financing activities totaled Yen 93,939 million in fiscal 2005, mainly resulting from a decrease in loan repayments accompanying the company’s strengthened financial position despite a large increase in the dividend payout. The Company paid dividends in fiscal 2005 of Yen 100 per share, which was an increase of Yen 35 per share over the prior year.
     Canon seeks to meet its liquidity and capital requirements principally with cash flow from operations. Consistent with this objective, Canon continued to reduce its reliance on external funding for capital investments in favor of relying upon internally generated cash flows. This approach is supplemented with group-wide treasury and cash management activities undertaken at the parent company level. Canon believes that its working capital is sufficient for its present requirements.
     To the extent Canon relies on external funding for its liquidity and capital requirements, it generally has access to various funding sources, including issuance of additional share capital, long-term debt or short-term loans. While Canon has been able to obtain funding from its traditional financing sources and from the capital markets, and believes it will continue to be able to do so in the future, there can be no assurance that adverse economic or other conditions will not affect Canon’s liquidity or long-term funding in the future.
     Short-term loans (including current portion of long-term debt) amounted to Yen 5,059 million at December 31, 2005 compared to Yen 9,879 million at December 31, 2004. Long-term debt (excluding their current portions) amounted to Yen 27,082 million at December 31, 2005 compared to Yen 28,651 million at December 31, 2004.
     Canon’s long-term debt generally consists of secured or partially-secured term loans from banks, bearing interest at fixed rates, lease obligations, as well as fixed-rate notes and convertible debentures which Canon has issued in the domestic market with original maturities of ten to fifteen years.
     In order to facilitate access to global capital markets, Canon obtains credit ratings from two rating agencies, Moody’s Investors Services, Inc. (“Moody’s”) and Standard and Poor’s Rating Services (“S&P”). In addition, Canon maintains a rating from Rating and Investment Information, Inc. (“R&I”), a rating agency in Japan, for access to the Japanese capital market.
     As of December 31, 2005, Canon’s debt ratings are: Moody’s: Aa2 (long-term); S&P: AA (long-term), A-1+ (short-term); and R&I: AA+ (long-term). Canon does not have any rating downgrade triggers that would accelerate the maturity of a material amount of its debt. A downgrade in Canon’s credit ratings or outlook could, however, increase the cost of its borrowings.

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     Capital expenditure in fiscal 2005 amounted to Yen 383,784 million compared with Yen 318,730 million in fiscal 2004 and Yen 210,038 million in fiscal 2003. In fiscal 2005, capital expenditures were mainly used to expand production capabilities in both domestic and overseas regions, and to bolster the Company’s R&D-related infrastructure. In addition, Canon has been continually investing in tools and dies for business machines, in which the amount invested is generally the same each year. For fiscal 2006, Canon projects its capital expenditures will be approximately Yen 465,000 million. The capital expenditures include investments in new production plants and new facilities of Canon.
     Employer contributions to Canon’s worldwide defined benefit pension plans were Yen 40,059 million in fiscal 2005, Yen 31,018 million in fiscal 2004, Yen 29,944 million in fiscal 2003. During fiscal 2006, Canon expects to make cash contributions of approximately Yen 45,352 million to its defined benefit pension plans.
     Working capital in fiscal 2005 increased Yen 130,954 million, to Yen 1,379,941 million, compared with Yen 1,248,987 million in fiscal 2004 and Yen 1,103,474 million in fiscal 2003. This increase was primarily a result of an increase in cash and cash equivalents. Canon believes its working capital will be sufficient for its requirements for the foreseeable future. Canon’s capital requirements are primarily dependent on management’s business plans regarding the levels and timing of capital expenditures and investments. The working capital ratio (ratio of current assets to current liabilities) for fiscal 2005 was 2.28 compared to 2.27 for fiscal 2004 and 2.33 for fiscal 2003.
     Return on assets (Net income divided by the average of total assets as of December 31, 2005, 2004 and 2003) recorded 10.1% in fiscal 2005, compared to 10.1% in fiscal 2004 and 9.0% in fiscal 2003. Return on stockholders’ equity was 16.0% in fiscal 2005 compared with 16.8% in fiscal 2004 and 15.9% in fiscal 2003.
     Debt to total assets ratio was 0.8%, 1.1% and 3.1% as of December 31, 2005, 2004 and 2003, respectively. Canon had short-term loans and long-term debt of Yen 32,141 million as of December 31, 2005, Yen 38,530 million as of December 31, 2004 and Yen 98,396 million as of December 31, 2003.
     C. Research and development, patents and licenses
     Year 2005 marks the final year of Phase II of the Excellent Global Corporation Plan, which started in 2001. The plan aims to guide Canon to the No.1 position worldwide in all core business areas and to build on its R&D capabilities to continually create new businesses. While working to bring Phase II to a successful conclusion, Canon is also making thorough preparations to pursue sound growth, its new target for Phase III, which begins in 2006.
     With respect to its R&D goals, Canon formulated a vision, which is to create a borderless environment between people and devices where images and information are exchanged in a way that lets us live and work the way we want, virtually anytime, anywhere. Toward the realization of its vision, Canon has accelerated the development and commercialization of display devices. In particular, Canon has developed SED devices with the aim of mass production at SED Inc., established in 2004. In addition, Canon has strengthened its R&D of such items as projectors and organic light-emitting diodes (“OLEDs”). Furthermore, Canon continues to promote activities giving rise to its next-generation businesses pursuing its search for new business domains, as well as to reinforce its R&D infrastructure.
     In regard to its R&D efficiencies, Canon has utilized of 3D-CAD systems, in order to accelerate product development and curtail costs. Moreover, Canon enhanced and evolved its simulation, measurement and analysis technologies, introducing a high-performance cluster computer and other leading-edge facilities in 2005. As such, Canon has succeeded in greatly reducing the need for prototypes, dramatically lowering costs and shortening development lead times.
     Canon has R&D centers worldwide, including the USA, that closely collaborate in their R&D activities. Some regional R&D centers conduct basic research into technology, and others apply their expertise to develop new products and businesses.
     The Company’s R&D activities are conducted in the following four organizations:
    Core Technology Development Headquarters (where component engineering and base technology R&D, such as optics technology, nanotechnology and production engineering, is conducted)
    Leading-Edge Technology Development Headquarters (where most advanced technology R&D, aiming to create new technological capabilities, is conducted)
    Platform Technology Development Headquarters (where platform technology R&D, such as system Large Scale Integration (“LSI”) chips, network technology and visual information technology, is conducted)
    Device Technology Development Headquarters (where key device R&D, such as for semiconductor devices, is conducted)
     Canon had R&D expenditures of Yen 286,476 million in fiscal 2005, Yen 275,300 million in fiscal 2004 and Yen 259,140 million in fiscal 2003. The ratios of R&D expenditure to total net sales for fiscal 2005, 2004 and 2003 were 7.6%, 7.9% and 8.1%, respectively.
     Canon believes that new products protected by seminal patents will not easily allow competitors to catch up with, and have advantages in establishing standards in the market and the industry. The United States Patent and Trademark Office announced that Canon obtained the second-greatest number of private sector patents in 2005. This achievement marks Canon’s fourteenth consecutive year as one of the top three patent-receiving private-sector organizations.

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     D. Trend information
Trend information
     Through Phase I (1996 to 2000) and Phase II (2001 to 2005) of its “Excellent Global Corporation Plan,” the Canon Group pursued total optimization. Under the policy of putting profits ahead of sales, we pushed forward selection and concentration measures and, amid ongoing product digitalization, worked to enhance our product competitiveness and establish corporate structure for high profitability.
     The business environment the Canon Group will face in the future will likely be characterized by ongoing economic globalization against the background of stable economic growth at the global level, as well as further adoption of broadband network and explosive growth of the digital imaging business sector.
     Viewing these conditions as a business opportunity, the Canon Group will continuously try to boldly apply the operational, technological, personnel, financial and other business resources it has built up in ways that make further sound growth possible. Toward that end, we have formulated a new five-year plan — Phase III (2006 to 2010) of our “Excellent Global Corporation Plan.”
     Chief among the priority strategies contained in this plan is making all of our current core businesses the overwhelming No.1 position and establishing our display technologies as businesses, a major new business for the Canon Group. And we aim to review our production systems in Japan through steps like the introduction and promotion of high-productivity automated systems, and we will establish new production systems to sustain international competitiveness. We will also expand our business operations through diversification and establish a Three Regional Headquarters System based in Japan, the U.S. and Europe, identify new business domains and accumulate the required technologies. Furthermore, we will also focus on nurturing strong individuals promoting these everlasting corporate reforms.
     By forcefully advancing these priority strategies, the Canon Group aims to create business operations that can prosper in perpetuity and make us a truly excellent global corporation.
Business machines segment
Office imaging products
     In the office imaging products segment, it has become more important to provide added value in the form of networking, integration, color printing, and multifunction models. Also, in addition to the mid segment products for office market which enjoys steady growth, Canon expects that the market of higher-end models and low-end multifunction models will expand as well. The market for color digital devices continued to grow rapidly, and sales of monochrome digital MFDs were stable, reflecting the market trend shifting from single-function to multifunction. Recently, there has been a new, printer-based MFP market created by other printer vendors as they seek to enter the copier and MFD market.
     To maintain and enhance a competitive edge and to meet more sophisticated customer demands, Canon is strengthening its marketing capabilities by reinforcing its hardware and software product lineups and by improving functionality. In 2005, Canon strengthened the product lineups of its color digital devices in addition to its existing full line of monochrome machines and maintained its market share by executing business strategies in line with the current market trend.
     While competitors seek to transfer manufacturing facilities to China, Canon regards its manufacturing bases in Japan important, in order to reduce total cost, through strengthening and reinforcing its technology, in particular through the collaboration of its R&D, manufacturing and quality management divisions. In fiscal 2005, Canon established a new global mother factory in Toride, to achieve the above-mentioned goal.
Computer peripheral products
     The inkjet printer market continues to grow steadily. Canon expects a continuation of declines in market prices, a shift from single-function printers to MFPs, and an expansion of the digital photo market. To manage these trends, Canon has established a line of MFPs from flagship to entry models in order to expand its printer sales.
     Canon’s laser beam printer business holds a strong position in the market. In the monochrome laser beam printer market, Canon expects that the transition to a low price segment will expand sales in the micro-business/home office market and in the emerging markets. In the color laser beam printer market, Canon expects continued strong growth in demand. In general, competition will become more intense as competitors implement aggressive price strategies in order to establish themselves as market leaders. Canon seeks to remain competitive by developing technologies that can be deployed in a timely fashion to produce innovative products in all segments. Canon is also working to lower costs by automating production of consumables and to secure procurement of essential parts through internal sourcing.
     Although Canon expects that the size of the scanner market will continue to contract, the stylish and compact CanoScan LiDE series and Hyper CCD models with ultrahigh-resolution were both introduced in fiscal 2005 in order to increase Canon’s share of this market.
     The size of the worldwide facsimile market has remained stable, as expansion in Asia, mainly China, has offset declines in other regions. Due to price declines for inkjet MFPs with facsimile function, prices are also declining for stand-alone machines.
Business information products
     With regard to personal computers, demand from corporate clients in the Japanese market held steady in fiscal 2005, but a decline in sales was caused by Canon’s change in marketing strategy from selling single products to a solutions business involving the proposal of unique combinations of various products. This trend is expected to continue in fiscal 2006.

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Cameras segment
     The entire digital camera market continues to expand. While the growth rate has slowed in Japan and the United States, emerging markets, especially China and Eastern Europe, have experienced strong growth. In addition, the emergence of new photo imaging systems has contributed to this growth as well, such as PC-free direct printing systems, by expanding the digital imaging functionality through network connectivity, along with the improvement of the user-friendly image processing interfaces and software.
     The digital camera industry is seeing growth on various fronts. As with most other digital consumer electronics, the digital camera market is now confronted with a fierce price war and intensified technological competition in terms of picture quality and functions. Profit margins have been shrinking for the overall industry, but Canon has been able to maintain higher margins through reforms of its production and procurement systems.
     Canon expects the market for compact digital cameras to expand in the intermediate term. However, profit margins for the overall industry are moving lower as prices fall and competition increases. Therefore, Canon plans to continue cutting production costs while expanding our presence in terms of quantity.
     There are signs of rapid growth in the market for compact photo printers, which present a new business opportunity. By creating a strong product line over the mid-term, Canon believes that it will be able to take a significant role in this market and turn the compact photo printer business into a new earnings source for Canon.
     Canon played a major role in the continued expansion of the digital SLR market in fiscal 2005. This market is expected to continue growing for the time being. However, Canon expects the growth rate to fall once this new demand has peaked.
     The market for film cameras is contracting as a result of the rapid shift to digital cameras. Canon anticipates this trend to continue, both for film SLR cameras and for film compact cameras.
     Canon expects the interchangeable lens market to grow as a result of the rapid market penetration of digital SLR cameras. In response to the rapid growth of the SLR camera market, Canon has strengthened its line of interchangeable lenses exclusively for digital SLR cameras, and currently has five models in this market. Canon seeks to expand its sales and market share by introducing products especially made for popular class digital SLR cameras.
     For video camcorders, analog camcorder sales have been further replaced by sales of digital camcorders in the United States in fiscal 2005, where the speed of transition used to be moderate. Against this background two new trends have emerged in the market. First, the introduction of video cameras using DVDs, HDDs, SD cards and other new forms of media has resulted in a trend in which convenience offered by the products is more emphasized. Second, the trend towards higher picture quality has evolved, provided by products using HDV and other high-resolution recording methods. Canon believes that these two trends are stimulating the market by responding to more diverse user needs and will likely contribute to further growth for the overall digital video market.
     Canon will seek to continue sales growth with a stronger product line for the Mini DV market as well as for the DVD and HDV market, while continuing to invest in R&D to follow new trends in the market.
     Canon expects that the market for liquid crystal projectors will continue to grow by about 20% per year on a unit basis, while market prices will continue to decline, resulting in moderate growth in monetary terms. Our independently developed SX50 high-resolution projector, which was introduced at the end of last year, has been winning praise in the market thanks to its picture quality and compact dimensions. This product is helping Canon capture a significant share of the market for high-resolution projectors. Canon will continue to make distinctive products that meet the demands of the projector market, such as greater brightness and resolution.
Optical and other products segment
     Canon expects new orders for semiconductor-production equipment to increase in fiscal 2006, as the market turns to the recovery phase following to the adjustment period in fiscal 2005. In general, the trend toward high resolution and higher speed equipment will likely to continue in the semiconductor industry. In order to manage theses trends, Canon introduced the FPA-6000AS4 in fiscal 2004, and the FPA-6000ES6a in fiscal 2005. Canon will continue to focus on developing new products in order to satisfy the semiconductor manufacturers who have various device patterns.
     For fiscal 2005, sales of aligners for the production of LCDs realized significant growth as the PC monitor industry continued to shift from CRT to LCD displays, and the LCD television market continued to expand. However, in the LCD production mask aligner market, demand is expected to decline gradually as the trend toward increased capital investment tapers off, and also due to the timing of the release of the brand-new models scheduled sometime next year, the order is expected to show a moderate decline.
     The TV lens market is enjoying a gradual recovery thanks to the improving economy and new demand as more broadcasting equipment switches over to digital. In fact, in 2005 the market returned to roughly the same level seen four years ago just before the September 11. Growth in demand for HDTV lenses until now has come mainly from Japan and the U.S., but Canon is now starting to see greater demand in Europe as well. Canon also expects to see new demand in China and other Asian markets thanks to the shift to digitalization. Though Canon already has a major market share worldwide for this class of lens, it intends to continue to strengthen its position in this market.
Forward looking statements
     The foregoing discussion and other disclosure in this report contains forward-looking statements that reflect management’s current views with respect to certain future events and financial performance. Actual results may differ materially from those projected or implied in the forward-looking statements. Further, certain forward-looking statements are based upon assumptions of future events that may not prove to be accurate. The following important factors could cause actual results to differ materially from those projected or implied in any forward-looking statements: foreign currency exchange rate fluctuations; the uncertainty of Canon’s ability to implement its plans to localize production and other measures to reduce the impact of foreign currency exchange rate fluctuations; uncertainty as to economic conditions, in Canon’s major markets; uncertainty of continued demand for Canon’s high-value-added products; uncertainty as to the recovery of computer and related markets; uncertainty of recovery in demand for Canon’s semiconductor production equipment; Canon’s ability to continue to develop products and to market products that incorporate new technology on a timely basis, are competitively priced and achieve market acceptance; the possibility of losses resulting from foreign currency transactions designed to reduce financial risks from changes in foreign currency exchange rates; and inventory risk due to shifts in market demand.

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     E. Off-balance sheet arrangements
     As part of its ongoing business, Canon does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
     Canon provides guarantees to third parties of bank loans of its employees, affiliates and other companies. Canon would have to perform under a guarantee, if the borrower defaults on a payment within the contract periods of 1 year to 30 years in the case of employees with housing loans, and of 1 year to 10 years in the case of affiliates and other companies. The maximum amount of undiscounted payments Canon would have had to make in the event of default by all borrowers was Yen 38,550 million at December 31, 2005. The carrying amounts of the liabilities recognized for Canon’s obligations as a guarantor under those guarantees are insignificant.
     F. Contractual obligations
The following summarizes Canon’s contractual obligations at December 31, 2005.
                                         
            Payments Due By Period  
            Less than                     More than  
    Total     1 year     1-3 years     3-5 years     5 years  
Contractual Obligations:
                                       
Long-Term Debt:
                                       
Capital Lease Obligations
  ¥ 8,784       4,159       4,064       538       23  
Other Long-Term Debt
    23,290       833       21,605       774       78  
Operating Lease Obligations
    52,589       14,571       18,693       9,823       9,502  
Purchase commitments for :
                                       
Property Plant and Equipment
    87,244       87,244                    
Parts and Raw Materials
    67,831       67,831                    
 
                             
Total
  ¥ 239,738       174,638       44,362       11,135       9,603  
 
                             
     Canon provides warranties generally less than one year against defects in materials and workmanship on most of its consumer products. Estimated product warranty related costs are established at the time revenue is recognized and are included in selling, general and administrative expenses. Estimates for accrued product warranty cost are primarily based on historical experience, and are affected by ongoing product failure rates, specific product class failures outside of the baseline experience, material usage and service delivery costs incurred in correcting a product failure. As of December 31, 2005, accrued product warranty costs amounted to Yen 16,746 million.
     At December 31, 2005, commitments outstanding for the purchase of property, plant and equipment approximated Yen 87,244 million, and commitments outstanding for the purchase of parts and raw materials approximated Yen 67,831 million, both for use in the ordinary course of its business. Canon anticipates that funds needed to fulfill these commitments will be generated internally through operations.
     Canon’s management believes that current financial resources, cash generated from operations and Canon’s potential capacity for additional debt and/or equity financing will be sufficient to fund current and future capital requirements.

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Item 6. Directors, Senior Management and Employees
     A.   Directors and senior management
     Directors and corporate auditors of the Company as of March 31, 2006 and their respective business experience are listed below.
             
Name   Position   Date of   Business experience
(Date of birth)   (Group executive/function)   commencement   (*current position/function)
Fujio Mitarai
 
Chairman, President & CEO
  4/1961   Entered the Company
(Sept. 23, 1935)
    1/1979   President of Canon U.S.A., Inc.
 
      3/1981   Director
 
      3/1985   Managing Director
 
      1/1989   In charge of HQ administration
 
      3/1989   Senior Managing Director
 
      3/1993   Executive Vice President
 
      9/1995   President & C.E.O.
 
      3/2006   Chairman, President & CEO*
             
Tsuneji Uchida
  Executive Vice President   4/1965   Entered the Company
(Oct. 30, 1941)
 
(Chief Executive of Image Communication Products Operations HQ)
  4/1995   Group Executive of Lens Products Group
 
    3/1997   Director
 
    4/1997  
Deputy Chief Executive of Camera Operations HQ/Group Executive of Photo Products Group
 
      4/1999   Chief Executive of Camera Operations HQ
 
      7/1999  
In charge of promotion of digital photo business
 
      1/2000  
In charge of promotion of digital photo home business
 
      1/2001  
Chief Executive of Image Communications Products HQ*
 
      3/2001   Managing Director
 
      3/2003   Senior Managing Director
 
      3/2006   Executive Vice President*
             
Toshizo Tanaka
  Senior Managing Director   4/1964   Entered the Company
(Oct. 8, 1940)
 
(Group Executive of Finance & Accounting HQ)
  1/1992  
Deputy Group Executive of Finance & Accounting HQ
 
    3/1995   Director
 
      4/1995   Group Executive of Finance & Accounting HQ*
 
      3/1997   Managing Director
 
      3/2001   Senior Managing Director*
             
Nobuyoshi Tanaka
  Senior Managing Director   4/1970   Entered the Company
(Dec. 23, 1945)
 
(Group Executive of Corporate Intellectual Property & Legal HQ)
  1/1991  
Senior General Manager of Semiconductor Production Equipment Development Center
 
    3/1993   Director
 
    4/1993   Chief Executive of Optical Products HQ
 
      4/1999  
Group Executive of Corporate Intellectual Property & Legal HQ*
 
      3/2001   Managing Director
 
      3/2006   Senior Managing Director*
             
Junji Ichikawa
  Senior Managing Director   4/1965   Entered Shiba Electronics Co., Ltd.
(Feb. 9, 1943)
 
(Chief Executive of Optical Products HQ)
  1/1970   Entered the Company
 
    4/1994   Group Executive of Peripheral Group 1
 
    3/1997   Director
 
      4/1997   Deputy Chief Executive of Peripheral Products HQ
 
      4/2000   Chief Executive of Peripheral Products HQ
 
      3/2001   Managing Director
 
      4/2003   Group Executive of Production Management HQ
 
      4/2004   Chief Executive of Optical Products HQ*
 
      3/2006   Senior Managing Director*
             

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Name   Position   Date of   Business experience
(Date of birth)   (Group executive/function)   commencement   (*current position/function)
Hajime Tsuruoka
  Senior Managing Director     3/1970     Entered Meiji Seika Kaisha Ltd.
(July 9, 1943)
        11/1973     Entered the Company
 
        4/1995     President of Canon Italia S.p.A.
 
        3/1997     Director
 
        9/1997     President of Canon Deutschland GmbH
 
        3/1999     President of Canon Europa N.V.*
 
        3/2001     Managing Director
 
        3/2006     Senior Managing Director*
             
Akiyoshi Moroe
  Managing Director     4/1968     Entered the Company
(Sept. 28, 1944)
 
(Group Executive of General Affairs HQ)
    7/1996    
Deputy Group of Executive of Human Resource Management & Organization HQ
 
        3/1999     Director
 
        4/1999     Group Executive of General Affairs HQ*
 
        10/2000    
Group Executive of Information & Communications Systems HQ
 
        3/2003     Managing Director*
             
Kunio Watanabe
  Managing Director     4/1969     Entered the Company
(Oct. 3, 1944)
 
(Group Executive of Corporate Strategy & Development HQ)
    4/1995    
Group Executive of Corporate Strategy & Development HQ*
 
        3/1999     Director
 
        3/2003     Managing Director*
             
Hironori Yamamoto
  Managing Director     4/1969     Entered the Company
(Dec. 23, 1943)
 
(Group Executive of Production Management HQ,
    1/1998    
Deputy Group Executive of Production Management HQ
 
 
Group Executive of Global Environment Promotion HQ)
    3/1999     Director
 
      7/1999    
Group Executive of Core Technology Development HQ/Deputy Group Executive of Display Development HQ
 
      4/2001     Group Executive of Display Development HQ
 
        3/2004     Managing Director*
 
        7/2005     Group Executive of Production Management HQ*
 
        3/2006    
Group Executive of Global Environment Promotion HQ*
             
Yoroku Adachi
  Managing Director     4/1970     Entered the Company
(Jan. 11, 1948)
        3/2001     Chairman of Canon Singapore Pte. Ltd.
 
             
Chairman of Canon HongKong Co., Ltd.
Director
 
        4/2003     President of Canon (China) Co., Ltd.
 
        3/2005     Managing Director *
 
        4/2005     President of Canon U.S.A., Inc.*
             
Yasuo Mitsuhashi
  Managing Director     4/1974     Entered the Company
(Nov. 23, 1949)
 
(Chief Executive of Peripheral Products HQ)
    2/2001     Chief Executive of Chemical Products HQ
 
      3/2001     Director
 
        4/2003     Chief Executive of Peripheral Products HQ*
 
        3/2005     Managing Director *
             
Katsuichi Shimizu
  Director     4/1970     Entered the Company
(Nov. 13, 1946)
 
(Chief Executive of Inkjet Products HQ)
    4/2001    
Deputy Chief Executive of Office Imaging Products HQ
 
        3/2003     Director*
 
        4/2003     Chief Executive of Inkjet Products HQ*
             
Ryoichi Bamba
  Director     4/1972     Entered the Company
(Nov. 25, 1946)
        4/1998     Senior Vice President of Canon U.S.A., Inc.
 
        2/2003     Executive Vice President of Canon U.S.A., Inc.*
 
        3/2003     Director*
             
Tomonori Iwashita
  Director     4/1972     Entered the Company
(Jan. 28, 1949)
 
(Deputy Chief Executive of Image Communication Products HQ)
    4/1999    
Senior General Manager of Camera Development Center
 
        1/2001     Group Executive of Photo Products Group
 
        3/2003     Director*
 
        4/2003    
Deputy Chief Executive of Image Communication Products HQ*
             

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Name   Position   Date of   Business experience
(Date of birth)   (Group executive/function)   commencement   (*current position/function)
Toshio Honma
  Director     4/1972     Entered the Company
(Mar. 10, 1949)
 
(Group Executive of L Printer Business Promotion HQ)
    4/2001    
Deputy Chief Executive of i Printer Products HQ
 
      3/2003     Director*
 
        4/2003     Group Executive of Business Promotion HQ
 
        7/2003    
Group Executive of L Printer Business Promotion HQ*
             
Shigeru Imaiida
  Director     4/1972     Entered the Company
(Sept. 16, 1948)
        8/1999    
Senior General Manager of Production Engineering Center
 
        3/2003     Director*
 
        4/2004     Group Executive of Production Management HQ
 
        7/2005    
Deputy Group Executive of Production Management HQ
 
        10/2005     Director of Canon ANELVA Co.
 
        3/2006     Senior Managing Director of Canon ANELVA Co.*
             
Masahiro Osawa
  Director     4/1971     Entered the Company
(May 26, 1947)
 
(Group Executive of Global Procurement HQ)
    7/1997     Vice President of Canon U.S.A., Inc.
 
      2/2003     Senior Vice President of Canon U.S.A., Inc.
 
        7/2003    
Deputy Group Executive of Finance & Accounting HQ
 
        3/2004     Director*
 
        4/2004     Group Executive of Global Procurement HQ*
             
Keijiro Yamazaki
  Director     4/1971     Entered the Company
(Oct. 14, 1948)
 
(Group Executive of Human Resource Management & Organization HQ,
Group Executive of Information & Communications Systems HQ)
    4/1999    
General Manager of Human Resource Management & Organization Div.
 
      1/2000    
Deputy Group Executive of Human Resource Management & Organization HQ
 
      3/2004     Director*
 
      4/2004    
Group Executive of Information & Communications Systems HQ*
 
        3/2006    
Group Executive of Human Resource Management & Organization HQ*
             
Shunichi Uzawa
  Director     8/1978     Entered the Company
(Jan. 26, 1949)
 
(Group Executive of Core Technology Development HQ)
    1/1998    
Senior General Manager of Nano-technology Research Center
 
        4/2001    
Deputy Group Executive of Display Development HQ
 
        3/2004     Director*
 
        4/2004     Group Executive of SED Development HQ
 
        10/2004     President of SED Inc.
 
        1/2006    
Group Executive of Core Technology Development HQ*
             
Masaki Nakaoka
  Director     4/1975     Entered the Company
(Jan. 3, 1950)
 
(Group Executive of Office Imaging Products HQ)
    1/1997    
Senior General Manager of Office Imaging Products Development Center 1
 
        4/1999    
Group Executive of Office Imaging Products Group 1
 
        4/2001    
Deputy Chief Executive of Office Imaging Products HQ
 
        3/2004     Director*
 
        4/2005     Chief Executive of Office Imaging Products HQ*
             
Toshiyuki Komatsu
  Director     4/1972     Entered the Company
(Jan. 19, 1950)
 
(Group Executive of Leading-Edge Technology Development HQ)
    1/1998     Senior General Manager of Canon Research Center
 
      1/2000    
Deputy Group Executive of Core Technology Development HQ
 
        3/2004     Director*
 
        4/2004    
Group Executive of Leading-Edge Technology Development HQ*
 
        7/2005    
Group Executive of Core Technology Development HQ
             
Shigeyuki Matsumoto
  Director     4/1977     Entered the Company
(Nov. 15, 1950)
 
(Group Executive of Device Technology Development Headquarters)
    1/2002    
Group Executive of Device Technology Development Headquarters*
 
      3/2004     Director*
             

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Name   Position   Date of   Business experience
(Date of birth)   (Group executive/function)   commencement   (*current position/function)
Haruhisa Honda
  Director     4/1974     Entered the Company
(Oct. 14, 1948)
 
(Chief Executive of Chemical Products Operations)
    4/1995    
Senior General Manager of Cartridge Development Center
 
        3/2004     Director*
 
        4/2004     Chief Executive of Chemical Products Operations*
             
Tetsuro Tahara
  Director     4/1971     Entered the Company
(Jan. 31, 1949)
        4/1999    
Senior General Manager of Office Imaging Products Production Management Center
 
        4/2002    
Deputy Chief Executive of Office Imaging Products HQ
 
        4/2003     President of Canon (Suzhou) Inc.*
 
        3/2006     Director*
             
Seijiro Sekine
  Director     4/1972     Entered the Company
(Oct. 20, 1948)
 
(Group Executive of Logistics HQ)
    4/1995    
General Manager of Business Information Systems Division
 
        1/2001    
Deputy Group Executive of Information & Communication Systems HQ
 
        10/2004     Group Executive of Logistics HQ*
 
        3/2006     Director*
             
Shunji Onda
  Director     4/1972     Entered the Company
(Mar. 13, 1950)
 
(Senior General Manager of Optical Products Business Administration Center)
    1/1999    
General Manager of Peripheral Products
Chief Executive Office
 
      1/2002     General Manager of Finance Division
 
      4/2004    
Senior General Manager of Optical Products Business Administration Center*
 
        3/2006     Director*
             
Teruomi Takahashi
  Corporate Auditor     9/1971     Entered the Company
(June 10, 1943)
        3/1999     Director
 
        4/1999     Chief Executive of Chemical Products HQ
 
        2/2001     Chief Executive of BJ Products HQ
 
        4/2001     Chief Executive of i Printer Products HQ
 
        4/2003     Chief Executive of Chemical Products HQ
 
        3/2004     Corporate Auditor *
             
Kunihiro Nagata
  Corporate Auditor     4/1970     Entered the Company
(Mar.16, 1948)
        1/1991    
General Manager of Business Machines Accounting Dept.
 
        4/1995    
Senior General Manager of Business Machines Accounting & Production Planning Center
 
        10/2000     General Manager of Corporate Planning Division
 
        1/2003    
Deputy Group Executive of Corporate Strategy Development HQ
 
        3/2004     Corporate Auditor *
             
Tadashi Ohe
  Corporate Auditor     4/1969     Registration as a lawyer*
(May 20, 1944)
        4/1989     Instructor of Judicial Training Institution
 
        3/1994     Corporate Auditor, the Company*
             
Yoshinobu Shimizu
  Corporate Auditor     3/1973     Registered as Certified Public Accountant*
(Oct. 26, 1944)
        6/1990     Representative Partner of Showa Ota & Co.
 
        5/2002    
Deputy Chief Executive Officer of Century Ota Showa & Co. (renamed Ernst & Young ShinNihon)
 
        3/2006     Corporate Auditor, the Company*
             
Minoru Shishikura
  Corporate Auditor     4/1976     Entered The Dai-Ichi Mutual Life Insurance Co.
(Sept. 13, 1953)
        4/1998    
General Manager of Metropolitan Corporate Loan Dept. of The Dai-Ichi Mutual Life Insurance Co.
 
        4/2000    
General Manager of Loan Department of The Dai-Ichi Mutual Life Insurance Co.
 
        4/2002    
General Manager of Credit Department of The Dai-Ichi Mutual Life Insurance Co.
 
        3/2006     Corporate Auditor, the Company*
             

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Term
     All directors and corporate auditors are elected by the shareholders at their general meeting.
     The term of office of directors is one year. The current term of all directors expires in March 2007. The term of office of corporate auditors is four years. The current term for Mr. Ohe expires in March 2007, while current terms for Mr. Takahashi and Mr. Nagata, who were elected in the general meeting of shareholders in March 2004, expire in March 2008, and current terms for Mr.Shimizu and Mr.Shishikura, who were newly elected in the general meeting of shareholders in March 2006, expires in March 2010.
     Board members and corporate auditors may serve any number of consecutive terms.
     There is no arrangement or understanding between any director or corporate auditor and any major shareholder, customer, supplier or other material stakeholders in connection with the selection of such director or corporate auditor.
Board of Directors and Corporate Auditors
     The Company’s articles of incorporation provide for a board of directors of not more than 30 members and for not more than five corporate auditors. Currently the number of board members is 26, and the number of corporate auditors is five. There is no maximum age limit for members of the board. Board members and corporate auditors may be removed from office at any time by a resolution of a general meeting of shareholders.
     The board of directors has ultimate responsibility for the administration of the Company’s affairs. By resolution, the board of directors designates, from among its members, representative directors, who have authority individually to represent the Company generally in the conduct of its affairs.
     Under the Commercial Code of Japan, board members must refrain from engaging in any business competing with the Company unless approved by a board resolution, and no board member may vote on a proposal, arrangement or contract in which that board member is deemed to be materially interested.
     The Commercial Code requires a resolution of the board of directors for a company to acquire or dispose of material assets, to borrow substantial amounts of money, to employ or discharge important employees such as corporate officers, and to establish, change or abolish material corporate organizations such as a branch office.
     The corporate auditors are not required to be certified public accountants, although Mr.Shimizu is a certified public accountant. At least half of corporate auditors must be persons who have not been either board members or employees of the Company or any of its subsidiaries. A corporate auditor may not at the same time be a board member or an employee of the Company or any of its subsidiaries. The corporate auditors have the statutory duty of examining the Company’s financial statements and the Company’s business reports to be submitted annually by the board of directors at the general meetings of shareholders and of reporting their opinions to the shareholders. They also have the statutory duty of supervising the administration by the board members of the Company’s affairs. They shall participate in the meetings of the board of directors but are not entitled to vote.
     The corporate auditors constitute the board of corporate auditors. Under “The Law to Revise Part of the Commercial Code and the Law Regarding Exceptional Rules of the Commercial Code Concerning Auditing, etc. of Stock Corporation”, the board of corporate auditors has a statutory duty to prepare and submit its audit report to the board of directors each year. A corporate auditor may note an opinion in the auditor report if a corporate auditor’s opinion is different from the opinion expressed in the audit report. The board of corporate auditors is empowered to establish audit principles, the method of examination by corporate auditors of the Company’s affairs and financial position and other matters concerning the performance of the corporate auditors’ duties. The Company does not have an audit committee.
     The amount of remuneration payable to the Company’s board members as a group and that of the Company’s corporate auditors as a group in respect of a fiscal year is subject to approval by a general meeting of shareholders. Within those authorized amounts, the compensation for each board member and corporate auditor is determined by the board of directors and a consultation of the corporate auditors, respectively. The Company does not have a remuneration committee.
     In fiscal 2004, Canon established a standing committees, the Internal Control Committee, with the president appointed as chairman of the group. The Internal Control Committee has built a highly effective internal control system unique to the Canon Group, which not only serves to ensure the reliability of the company’s financial reporting, but also aims to ensure the effectiveness and efficiency of its business operations, as well as compliance with related laws, regulations, and internal controls.
     Additionally, in fiscal 2005, the Disclosure Committee was established with the president appointed as chairman. This committee was formed to ensure that Canon is not only in compliance with applicable laws, rules and regulations, but also to ensure that information disclosed to shareholders and capital markets is both correct and comprehensive.
     B. Compensation
     In the fiscal year ended December 31, 2005, the Company paid approximately Yen 1,442 million, in total to directors and corporate auditors. This amount includes bonuses but excludes retirement allowances.
     Directors and corporate auditors are not covered by the Company’s retirement program. However, in accordance with customary Japanese business practices, directors and corporate auditors receive lump-sum retirement benefits, subject to shareholder approval. The Company paid retirement benefits aggregating Yen 120 million to two directors during the fiscal year ended December 31, 2005.
     The Company does not have a stock option plan for directors, corporate auditors or any other employees.

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     C. Board practices
     See Item 6A “Directors and senior management” and Item 6B “Compensation.”
     D. Employees
     Following table lists the number of Canon’s full-time employees as of December 31, 2005, 2004 and 2003.
                                         
    Total     Japan     Americas     Europe     Others  
December 31, 2005
                                       
Business machines
    77,906       29,964       7,297       8,988       31,657  
Cameras
    18,308       5,263       1,552       1,405       10,088  
Optical and other products
    13,762       8,249       999       435       4,079  
Corporate
    5,607       5,161       90       94       262  
 
                             
Total
    115,583       48,637       9,938       10,922       46,086  
 
                             
 
                                       
December 31, 2004
                                       
Business machines
    74,772       29,928       7,833       8,997       28,014  
Cameras
    16,534       5,008       1,400       1,402       8,724  
Optical and other products
    11,397       6,458       908       391       3,640  
Corporate
    5,554       4,709       117       108       620  
 
                             
Total
    108,257       46,103       10,258       10,898       40,998  
 
                             
 
                                       
December 31, 2003
                                       
Business machines
    70,214       29,734       7,820       9,520       23,140  
Cameras
    15,856       4,698       1,318       1,006       8,834  
Optical and other products
    11,308       6,580       908       619       3,201  
Corporate
    5,189       4,368       134       162       525  
 
                             
Total
    102,567       45,380       10,180       11,307       35,700  
 
                             
Note:
Effective January 2004, Canon has changed the classification of its information system business. The information system business which had been included in “Optical and other products”, was reclassified as “Business machines (Office imaging products)” in order to better reflect its relation with the other products of the business machines group. Accordingly, information for previous fiscal years has been reclassified to conform with the current classification.
     There was an increase of approximately 7,300 employees as of the end of fiscal 2005 as compared to the end of fiscal 2004. This increase is mainly due to employment increases in the Asian region to accommodate production increases, as well as the effect of the newly acquired companies in Japan.
     Canon had approximately 45,800 temporary employees on average during fiscal 2005. This number includes seasonal workers as well as temp-staff employees such as security staff, meal service staff and janitorial staff.
     The Company and its subsidiaries have their own independent labor union. Canon has not experienced a labor strike since its establishment. The Company believes that the relationship between Canon and its labor union is good.

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E. Share ownership
     The following table lists the number of shares owned by the directors and corporate auditors of the Company as of March 31, 2006. The total is 216,086 shares constituting 0.02% of all outstanding shares.
             
Name   Position   Number of shares  
Fujio Mitarai
  Chairman, President & CEO     60,800  
Tsuneji Uchida
  Executive Vice President     5,600  
Toshizo Tanaka
  Senior Managing Director     11,768  
Nobuyoshi Tanaka
  Senior Managing Director     12,355  
Junji Ichikawa
  Senior Managing Director     10,531  
Hajime Tsuruoka
  Senior Managing Director     7,695  
Akiyoshi Moroe
  Managing Director     10,955  
Kunio Watanabe
  Managing Director     8,235  
Hironori Yamamoto
  Managing Director     4,900  
Yoroku Adachi
  Managing Director     6,095  
Yasuo Mitsuhashi
  Managing Director     4,985  
Katsuichi Shimizu
  Director     5,625  
Ryoichi Bamba
  Director     3,000  
Tomonori Iwashita
  Director     3,700  
Toshio Honma
  Director     6,595  
Shigeru Imaiida
  Director     4,535  
Masahiro Osawa
  Director     3,295  
Keijiro Yamazaki
  Director     3,100  
Shunichi Uzawa
  Director     3,395  
Masaki Nakaoka
  Director     2,000  
Toshiyuki Komatsu
  Director     1,400  
Shigeyuki Matsumoto
  Director     2,235  
Haruhisa Honda
  Director     2,926  
Tetsuro Tahara
  Director     435  
Seijiro Sekine
  Director     2,560  
Shunji Onda
  Director     2,435  
Teruomi Takahashi
  Corporate Auditor     7,231  
Kunihiro Nagata
  Corporate Auditor     1,300  
Tadashi Ohe
  Corporate Auditor     15,400  
Yoshinobu Shimizu
  Corporate Auditor    
Minoru Shishikura
  Corporate Auditor     1,000  
 
         
 
  Total     216,086  
 
         
     The Company and certain of its subsidiaries encourage its employees to purchase shares of their Common Stock in the market through an employees’ stock purchase association.

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Item 7. Major Shareholders and Related Party Transactions
     A. Major shareholders
     The table below shows the number of The Company’s shares held by the top ten holders of the Company’s shares and their percentage ownership as of December 31, 2005:
                 
Name of major shareholder   Shares owned     Percentage  
    (In thousands)          
The Dai-Ichi Mutual Life Insurance Co.
    59,090       6.7 %
Moxley and Co.
    49,388       5.6 %
Japan Trustee Services Bank, Ltd.
    48,360       5.4 %
(Trust Account)
               
The Master Trust Bank of Japan, Ltd.
    39,888       4.5 %
(Trust Account)
               
State Street Bank and Trust Company 505103
    24,740       2.8 %
State Street Bank and Trust Company
    21,629       2.4 %
Nomura Securities Co., Ltd.
    19,735       2.2 %
Mizuho Corporate Bank, Ltd.
    18,946       2.1 %
The Chase Manhattan Bank, N.A. London
    18,653       2.1 %
Sompo Japan Insurance Inc.
    15,273       1.7 %
     Canon’s major shareholders do not have different voting rights from other shareholders.
     As of December 31, 2005, 21.4% of the outstanding shares of common stock were held of record by 248 residents of the United States of America.
     The Company is not directly or indirectly owned or controlled by any other corporation, by any government, or by any other natural or legal person or persons severally or jointly.
     B. Related party transactions
     Since the beginning of Canon’s last full fiscal year, Canon has not transacted with, nor does Canon currently plan to transact with a related party (other than certain transactions with subsidiaries of the Company). For purposes of this paragraph, a related party includes: (a) enterprises that directly or indirectly through one or more intermediaries, control or are controlled by, or are under common control with, Canon; (b) associates; (c) individuals owning, directly or indirectly, an interest in the voting power of Canon that gives them significant influence over Canon, and close members of any such individual’s family; (d) key management personnel, that is, those persons having authority and responsibility for planning, directing and controlling the activities of Canon, including directors and senior management of companies and close member of such individual’s families; (e) enterprises in which a substantial interest in the voting power is owned, directly or indirectly, by any person described in (c) or (d) or over which such a person is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of Canon and enterprises that have a member of key management in common with Canon. Close members of an individual’s family are those that may be expected to influence, or be influenced by, that person in their dealings with Canon. An associate is an unconsolidated enterprise in which Canon has a significant influence or which has significant influence over Canon. Significant influence over an enterprise is the power to participate in the financial and operating policy decisions of the enterprise but is less than control over those policies. Shareholders beneficially owning a 10% interest in the voting power of the Company are presumed to have a significant influence on Canon.
     To the Company’s knowledge, no person owned a 10% interest in the voting power of the Company as of March 31, 2006.
     In the ordinary course of business on an arm’s length basis, Canon purchases and sells materials, supplies and services from and to its affiliates accounted for by the equity method. There are 13 affiliates which are accounted for by the equity method. Canon does not consider the amounts of the transactions with the above affiliates to be material to its business.
     C. Interests of experts and counsel
     Not Applicable.

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Item 8. Financial Information
     A. Consolidated financial statements and other financial information
Consolidated financial statements
     This Annual Report contains consolidated financial statements as of December 31, 2005 and 2004 and for each of the three years in the period ending December 31, 2005 prepared in accordance with U.S. generally accepted accounting principles and audited in accordance with the standards of the Public Company Accounting Oversight Board (United States) by an Independent Registered Public Accounting Firms. The financial statements as of and for the years ended December 31, 2005 and 2004 have been audited by Ernst & Young ShinNihon, while the financial statements for periods ended prior to December 31, 2004, were audited by KPMG AZSA & Co., and audit reports covering each of the periods are included in Item17 of this report.
     Refer to Item 17, Consolidated Financial Statements and Notes to Consolidated Financial Statements.
Legal proceedings
     Other than as described below, neither the Company nor its subsidiaries are involved in any litigation or other legal proceedings that, if determined adversely to the Company or its subsidiaries, would individually or in the aggregate have a material adverse effect on the Company or its operations.
    On December 17, 2002, the European Commission instituted an investigation into the printer and supply market. Canon received a questionnaire in connection with the investigation of the printer and supply market on January 3, 2003 and Canon has submitted its response. The investigation is yet to be closed.
 
    On January 16, 2003, the Dusseldorf District Court in Germany issued rulings in Canon’s favor in two patent infringement actions filed by Canon against Pelikan Hardcopy Deutschland GmbH and Pelikan Hardcopy European Logistics & Services GmbH (collectively, “Pelikan Hardcopy”). Pelikan Hardcopy has appealed the decision. On November 20, 2003, the Dusseldorf District Court in Germany issued a ruling in Canon’s favor in another patent infringement action filed by Canon against Pelikan Hardcopy. Pelikan Hardcopy has appealed the decision. The Dusseldorf High Court issued rulings in Canon’s favor in one of the three appeals by Pelikan Hardcopy. On November 17, 2005, the Dusseldorf High Court issued rulings in Canon’s favor in another of the three appeals by Pelikan Hardcopy. The remaining one of the appeals has been suspended by the Court since April 19, 2004.
 
    In October 2003, on-the-spot investigation was made against Canon by the Japanese Fair Trade Commission (“FTC”). Their allegation against us was that Canon was interfering with the businesses of the cartridge remanufacturers by frequently changing the design of color LBP cartridges. This investigation was terminated by FTC on October 21, 2004, without taking any action.
 
    In November 2003, a lawsuit was filed by a former employee against the Company at the Tokyo District Court in Japan. The lawsuit alleges that the former employee is entitled to Yen 45.9 billion as compensation for an invention related to certain technology used by the Company, and the former employee has sued for a partial payment of Yen 1 billion and interest thereon. The case is still pending and the final outcome is not yet determinable.
 
    In February 2003, a lawsuit was filed by St. Clair Intellectual Property Consultants, Inc. (“St. Clair”) against the Company and one of its subsidiaries in the United States District Court of Delaware, which accused the Company of infringement of patents related to certain technology. In connection with this case, in October 2004, a jury preliminarily found damages against the Company of approximately Yen 4 billion based on a percentage of certain product sales in the United States through 2003. Subsequent to this jury finding, St. Clair also made a motion to the court for damages relating to certain 2004 sales, using the same royalty rate awarded by the jury. There are additional defenses that are yet to be litigated in a follow-up non-jury trial solely before a judge; thus, a final decision by the court has not yet been reached. In March 2006, the Company and St. Clair have entered into a settlement agreement, pursuant to which they have agreed to settle the lawsuit and withdraw it.
 
    In Germany, Verwertungsgesellschaft Wort (“VG Wort”), a collecting agency representing certain copyright holders, has filed a series of lawsuits seeking to impose copyright levies upon digital products such as PCs and printers, that allegedly enable the reproduction of copyrighted materials, against the companies importing and distributing these digital products. In May 2004, VG Wort filed a civil lawsuit against Hewlett-Packard GmbH seeking for levies on multi-function printers. This is an industry test case under which Hewlett-Packard GmbH represents other companies sharing common interests, and Canon has undertaken to be bound by the final decision of this court case. The court of first instance and the court of appeals held that the multi-function printers were subject to a levy. In particular, the court of appeals ordered Hewlett-Packard GmbH to pay the amount equivalent to the levies imposed on photocopiers (EUR 38.35 to EUR 613.56 per unit, depending on printing speed and color printing capability). This lawsuit is currently under appeal before the German Federal Supreme Court. With regard to single-function printers, VG Wort filed a separate lawsuit on January 3, 2006 against Canon seeking for payment of copyright levies. Canon, other companies and the industry associations have expressed opposition to such extension of the levy scope and the final conclusion of these court cases including the amount of levies to be imposed, remains uncertain.
 
    On April 16, 2004, Canon filed two patent infringement actions against Recycle • Assist Co., Ltd. (“Recycle • Assist”) before the Tokyo District Court. On December 8, 2004, the Tokyo District Court issued rulings in Recycle • Assist’s favor in the two actions. On December 21, 2004, Canon appealed against the decisions of the two actions. On January 31, 2006, the Intellectual Property High Court issued a ruling in favor of Canon in one of the two appeal cases. On February 13, 2006, Recycle • Assist further appealed against this ruling of the Intellectual Property High Court. The remaining appeal case is pending before the Intellectual Property High Court.
Dividend policy
     Dividends are proposed by the Board of Directors of the Company based on the year-end non-consolidated financial statements of the Company, and are approved at the ordinary general meeting of shareholders, which is held in March of each year. Record holders of the Company’s American Depositary Receipts (ADRs) on the dividends’ record date are entitled to receive payment in full of the declared dividend. In addition to annual dividends, by resolution of the Board of Directors, the Company may declare a cash distribution as an interim dividend. The record date for the Company’s year-end dividends and for the interim dividends are December 31 and June 30, respectively.
     Since 1996, under the two five-year initiatives — Phases I and II of the Excellent Global Corporation Plan — the Canon Group has been working towards increasing its corporate value. During this period, management has focused on profitability and cash flow, which has led to greater competitiveness of its products and a stronger financial position.

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     Going forward, Canon will positively invest in strategic areas to accelerate growth, and will also place priority on actively returning profits to shareholders as an important management measure, taking full advantage of its strengthened financial base, which is attributable to the two five-year plans.
     As for returning profits to shareholders, Canon has worked to raise its dividend per share in accordance with the company’s policy of providing a stable dividend. Under the new policy, Canon will actively work to return profits to shareholders, mainly in the form of a dividend, taking into consideration planned future investments, free cash flow, and the company’s consolidated business performance.
     Canon has finished this year, the final year of Phase II of the Excellent Global Corporation Plan, by achieving increases in both sales and profits, and also significantly exceeding the targets that were set out for Phase II. Accordingly, in response to the continued support of shareholders and based on the new policy on returning profits to shareholders, Canon has increased its full-year dividend per share from Yen 65 in 2004, to Yen 100 for fiscal year 2005.
     B. Significant changes
     No significant change has occurred since the date of the annual financial statements.
Item 9. The Offer and Listing
     A. Offer and listing details
Trading in domestic markets
     The common stock of the Company has been listed on the Tokyo Stock Exchange (TSE), the principal stock exchange market in Japan, since 1949, and is traded on the First Section of the TSE. The shares are also listed on four other regional markets in Japan.
     The following table lists the reported high and low sales prices of the shares on the TSE and the closing highs and lows of the Tokyo Stock Price Index (TOPIX) and Nikkei Stock Average for the five most recent years. TOPIX is an index of the market value of stocks listed on the First Section of the TSE. The Nikkei Stock Average, an index of 225 selected stocks on the First Section of the TSE, is another widely accepted index.
                                                 
    TSE     TOPIX     Nikkei Stock Average  
    (Canon Inc.)     (Reference data)     (Reference data)  
    (Japanese yen)     (Points)     (Japanese yen)  
Period   High     Low     High     Low     High     Low  
2001 Year
  ¥ 5,330     ¥ 3,150       1,441.00       983.00     ¥ 14,529.41     ¥ 9,504.41  
2002 Year
    5,250       3,620       1,144.02       807.35       11,979.85       8,303.39  
2003 Year
    6,210       3,910       1,114.40       770.46       11,161.71       7,607.88  
2004 1(st) quarter
    5,670       4,920       1,189.38       1,017.84       11,869.00       10,299.43  
    2(nd) quarter
    5,820       5,220       1,225.97       1,051.57       12,195.66       10,489.84  
    3(rd) quarter
    5,810       4,910       1,197.74       1,073.69       11,988.12       10,545.89  
    4(th) quarter
    5,540       5,030       1,149.85       1,068.85       11,500.95       10,575.23  
2004 Year
    5,820       4,910       1,225.97       1,017.84       12,195.66       10,299.43  
2005 1(st) quarter
    5,790       5,190       1,206.93       1,128.75       11,975.46       11,212.63  
    2(nd) quarter
    6,000       5,380       1,202.46       1,104.30       11,911.90       10,770.58  
    3(rd) quarter
    6,190       5,380       1,430.80       1,174.16       13,678.44       11,540.93  
    4(th) quarter
    7,170       5,940       1,673.18       1,363.66       16,445.56       12,996.29  
2005 Year
    7,170       5,190       1,673.18       1,104.30       16,445.56       10,770.58  
                                                 
    TSE     TOPIX     Nikkei Stock Average  
    (Canon Inc.)     (Reference data)     (Reference data)  
    (Japanese yen)     (Points)     (Japanese yen)  
Period   High     Low     High     Low     High     Low  
2005 July
  ¥ 6,130     ¥ 5,530       1,207.48       1,174.92     ¥ 11,913.50     ¥ 11,540.93  
    August
    5,710       5,380       1,283.23       1,174.16       12,612.16       11,614.71  
    September
    6,190       5,520       1,430.80       1,274.63       13,678.44       12,498.40  
    October
    6,460       5,940       1,447.45       1,363.66       13,783.60       12,996.29  
    November
    6,870       6,110       1,553.27       1,444.73       15,013.24       13,606.50  
    December
    7,170       6,760       1,673.18       1,538.99       16,445.56       14,880.18  
2006 January
    7,320       6,850       1,721.92       1,538.85       16,754.60       15,059.52  
    February
    7,370       6,970       1,719.17       1,568.50       16,777.37       15,389.58  
    March
    7,930       7,160       1,735.25       1,595.93       17,125.64       15,553.14  

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Trading in foreign markets
     The Company’s ADRs are listed on the New York Stock Exchange (NYSE) and the Company’s Global Bearer Certificates (GBCs) are listed on the Frankfurt Stock Exchange.
     Since the Company’s 1969 public offering in the United States of U.S.$9,000,000 principal amount of its 6 1/2 % Convertible Debentures due 1984, there has been limited trading in the over-the-counter market in the Company’s ADRs. Since March 16, 1998, each ADR represents one share of the Company’s common stock. The Company’s ADSs had been quoted on the National Association of Securities Dealers Automated Quotation system (“NASDAQ”) since 1972 under the symbol CANNY to September 13, 2000.
     On September 14, 2000, Canon listed its ADSs on the NYSE under the symbol CAJ. The table below displays historical transition of high and low prices of our ADSs on NYSE.
                 
    NYSE  
    (Canon Inc.)  
    (U.S. dollars)  
Period   High     Low  
2001 Year
  $ 42.900     $ 26.480  
2002 Year
    40.400       30.150  
2003 Year
    53.000       33.730  
2004 1(st) quarter
    52.630       46.680  
    2(nd) quarter
    53.940       46.920  
    3(rd) quarter
    53.350       44.440  
    4(th) quarter
    54.390       47.290  
2004 Year
    54.390       44.440  
2005 1(st) quarter
    54.490       50.530  
    2(nd) quarter
    55.710       51.000  
    3(rd) quarter
    55.050       48.960  
    4(th) quarter
    60.420       51.570  
2005 Year
    60.420       48.960  
                 
    NYSE  
    (Canon Inc.)  
    (U.S. dollars)  
Period   High     Low  
2005 July
  $ 55.050     $ 48.960  
    August
    51.970       49.010  
    September
    54.280       50.400  
    October
    56.060       51.570  
    November
    57.840       52.300  
    December
    60.420       57.010  
2006 January
    63.920       59.540  
    February
    62.900       59.440  
    March
    66.930       60.650  
   The depositary and agent of the ADRs is JPMorgan Chase Bank, located at 1 Chase Manhattan Plaza, New York, N.Y. 10081, U.S.A.
   Co-ownership shares in a GBCs are listed on the Frankfurt Stock Exchange.
   B. Plan of distribution
     Not applicable.
   C. Markets
     See Item 9A “Offer and Listing Details.”

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Item 10. Additional Information

     A. Share capital

     Not applicable.

     B. Memorandum and articles of association

Objects and Purposes in Canon Inc. (the “Company”)’s Articles of Incorporation

       Objects of the Company provided in Article 2 of the Company’s Articles of Incorporation shall be to engage in the following business:

(1)   Manufacture and sale of optical machineries and instruments of various kinds.
 
(2)   Manufacture and sale of acoustic, electrical and electronic machineries and instruments of various kinds.
 
(3)   Manufacture and sale of precision machineries and instruments of various kinds.
 
(4)   Manufacture and sale of medical machineries and instruments of various kinds.
 
(5)   Manufacture and sale of general machineries, instruments and equipments of various kinds.
 
(6)   Manufacture and sale of parts, materials, etc. relative to the products mentioned in each of the preceding items.
 
(7)   Production and sale of software products.
 
(8)   Manufacture and sale of pharmaceutical products
 
(9)   Telecommunications business, and information service business such as information processing service business, information providing service business, etc.
 
(10)   Contracting for telecommunications works, electrical works and machinery and equipment installation works.
 
(11)   Sale, purchase and leasing of real properties and contracting for architectural works.
 
(12)   Manpower providing business, property leasing business and travel business.
 
(13)   Business relative to investigation, analysis of the environment and purification process of soil, water, etc.
 
(14)   Any and all business relative to each of the preceding items.

Provisions Regarding Directors

     There is no provision in the Company’s Articles of Incorporation as to a Director’s power to vote on a proposal, arrangement or contract in which the Director is materially interested, but, under the Commercial Code of Japan, a director is required to refrain from voting on such matters at meetings of the board of directors.

     The Commercial Code provides that compensation for directors is determined at a general meeting of shareholders of a company. Within the upper limit approved by the shareholders’ meeting, the board of directors will determine the amount of compensation for each director. The board of directors may, by its resolution, leave such decision to the discretion of the company’s representative director.

     The Commercial Code provides that the incurrence by a company of a significant loan from a third party should be approved by the company’s board of directors. The Company’s Regulations of the Board of Directors have adopted this policy.

     There is no mandatory retirement age for the Company’s Directors under the Commercial Code or its Articles of Incorporation.

     There is no requirement concerning the number of shares an individual must hold in order to qualify him as a Director of the Company under the Commercial Code or its Articles of Incorporation.

Holding of Shares by Foreign Investors

     Other than the Japanese unit share system that is described in “Rights of Shareholders - Japanese Unit Share System” below, there are no limitations on the rights of non-residents or foreign shareholders to hold or exercise voting rights on the Company’s shares imposed by the laws of Japan or the Company’s Articles of Incorporation or other constituent documents.

Rights of Shareholders

     Set forth below is information relating to the Company’s common stock, including brief summaries of the relevant provisions of its Articles of Incorporation and Regulations for Handling of Shares, as currently in effect, and of the Commercial Code of Japan and related legislation.

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General
     The Company’s authorized share capital is 2,000,000,000 shares, of which 888,742,779 shares were issued and outstanding as of December 31, 2005. Under the Commercial Code, shares must be registered and are transferable by delivery of share certificates. In order to assert shareholders’ rights against the Company, a shareholder must have its name and address registered on its register of shareholders, in accordance with the Company’s Regulations for Handling of Shares.
     A holder of shares may choose, at its discretion, to participate in the central clearing system for share certificates under the Law Concerning Central Clearing of Share Certificates and Other Securities of Japan. Participating shareholders must deposit certificates representing all of the shares to be included in this clearing system with the Japan Securities Depository Center, Inc. (the “Securities Center”). If a holder is not a participating institution in the Securities Center, it must participate through a participating institution, such as a securities company or bank having a clearing account with the Securities Center. All shares deposited with the Securities Center will be registered in the name of the Securities Center on the Company’s register of shareholders. Each participating shareholder will in turn be registered on the Company’s register of beneficial shareholders and be treated in the same way as shareholders registered on its register of shareholders. For the purpose of transferring deposited shares, delivery of share certificates is not required. Entry of the share transfer in the books maintained by the Securities Center for participating institutions, or in the book maintained by a participating institution for its customers, has the same effect as delivery of share certificates. The registered beneficial owners may exercise the rights attached to the shares, such as voting rights, and will receive dividends (if any) and notices to shareholders directly from the Company. The shares held by a person as a registered shareholder and those held by the same person as a registered beneficial owner are aggregated for these purposes. Beneficial owners may at any time withdraw their shares from deposit and receive share certificates, subject to the limitations caused by the Japanese unit share system described below.
     A new law to establish a new central clearing system for shares of listed companies and to eliminate the issuance and use of certificates for such shares was promulgated in June 2004 and the relevant law will come into effect within five years of the date of promulgation. On the effective date, a new central clearing system will be established and the shares of all Japanese companies listed on any Japanese stock exchange, including the Company’s shares, will be subject to the new central clearing system. On the same day, all existing share certificates for share of all Japanese companies listed on any Japanese stock exchange, including the Company’s shares, will become null and void and the transfer of such shares will be effected through entry in the books maintained under the new central clearing system.
     The registered beneficial holder of deposited shares underlying the ADSs is the depositary for the ADSs. Accordingly, holders of ADSs will not be able to directly assert shareholders’ rights.
Dividends
     Under the Company’s Articles of Incorporation, its financial accounts will be closed on December 31 of each year and dividends, if any, will be distributed to shareholders (or pledgees) written or recorded in the register of shareholders as of the close of business on that date following approval at its ordinary general meeting of shareholders. In addition, by resolution of the board of directors, the Company may distribute interim dividends to the shareholders (or pledgees) written or recorded in the register of shareholders as of June 30 each year. Dividends will be distributed in cash.
     The Commercial Code provides that, until the aggregate amount of the Company’s legal reserve and additional paid-in capital is at least one-quarter of its stated capital, it may not make any distribution of profits by way of annual cash dividends or interim dividends unless it sets aside in its legal reserve an amount equal to at least one-tenth of any amount that it pays out as an appropriation of retained earnings, including any payment by way of annual or interim dividends and bonuses to Directors and Corporate Auditors. The Commercial Code will permit the Company to distribute profits by way of dividends out of the excess of the net assets, on a non-consolidated basis, over the aggregate of:
(1)   the stated capital;
 
(2)   the additional paid-in capital;
 
(3)   the accumulated legal reserve;
 
(4)   the legal reserve to be set aside in respect of the dividends concerned and proposed payment by way of appropriation of retained earnings; and
 
(5)   other matters specified in the Implementation Ordinance of the Commercial Code.
     In the case of interim dividends, the net assets are calculated by reference to the non-consolidated balance sheet as at the last closing of the Company’s accounts, but adjusted to reflect (i) any subsequent payment by way of appropriation of retained earnings and transfer to legal reserve in respect thereof, (ii) any subsequent transfer of retained earning to stated capital, (iii) if it has been authorized, pursuant to a resolution of a general meeting of shareholders, to purchase shares (see “Repurchase by the Company of Shares” below) the total amount of the purchase price of such share so authorized by such resolution that may be paid by the Company and (iv) other matters specified in the Implementation Ordinance of the Commercial Code. Interim dividends may not be paid where there is a risk that at the end of the fiscal year there might not be any excess of net assets over the aggregate of the amounts referred to in (1) through (5) above.
Stock Splits
     The Commercial Code permits the Company, by resolution of its board of directors, to make stock splits, regardless of the value of net assets (as appearing in its latest non-consolidated balance sheet) per share. Under the Commercial Code, when the Company issues new shares in the future, the entire amount of issue price of those new shares is required to be accounted for as stated capital, although it may account for an amount not exceeding one-half of the issue price as additional paid-in capital. By resolution of the Company’s board of directors, the Company may make a stock split within an amount of stated capital or by transferring the whole or any part of additional paid-in capital and legal reserve to stated capital.

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     Under the Commercial Code, by resolution of the Company’s board of directors, the Company may increase the authorized shares up to the number reflecting the rate of stock splits and amend its Articles of Incorporation by resolution of its board of directors to this effect without the approval of a shareholders’ meeting. For example, if each share became three shares by way of a stock split, the Company may increase the authorized shares from the current 2,000,000,000 shares to 6,000,000,000 shares.
Japanese Unit Share System
     The Company’s Articles of Incorporation provided that 100 shares of common stock constitute one “unit”. The Commercial Code of Japan permits the Company, by resolution of its board of directors, to reduce the number of shares which constitutes one unit or abolish the unit share system, and amend its Articles of Incorporation to this effect without the approval of a shareholders’ meeting.
Transferability of Shares Representing Less than One Unit
     The Company may not issue share certificates for a number of shares not constituting an integral number of units, except in limited circumstances. Because the transfer of shares normally requires delivery of the share certificates for the shares being transferred, shares constituting a fraction of a unit and for which no share certificates are issued may not be transferable. Because transfer of ADRs does not require a change in the ownership of the underlying shares, holders of ADRs evidencing ADSs that constitute less than one unit of shares are not affected by these restrictions in their ability to transfer the ADRs.
     However, because transfers of less than one unit of the underlying shares are normally prohibited under the unit share system, the deposit agreement provides that the right of ADR holders to surrender their ADRs and withdraw the underlying shares for sale in Japan may only be exercised as to whole units.
Right of a Holder of Shares Representing Less than One Unit to Require the Company to Purchase Its Shares
     A holder of shares representing less than one unit may at any time require the Company to purchase its shares. These shares will be purchased at (a) the closing price of the shares reported by the Tokyo Stock Exchange, Inc. (the “Tokyo Stock Exchange”) on the day when the request to purchase is made or (b) if no sale takes place on the Tokyo Stock Exchange on that day, then the price at which sale of shares is effected on such stock exchange immediately thereafter. In such case, the Company will request payment of an amount equal to the brokerage commission applicable to the shares purchased pursuant to its Regulations for Handling of Shares. However, because holders of ADSs representing less than one unit are not able to withdraw the underlying shares from deposit, these holders will not be able to exercise this right as a practical matter.
Right of a Holder of Shares Representing Less than One Unit to Purchase from the Company its Shares up to a Whole Unit
     The Articles of Incorporation of the Company provide that a holder of shares representing less than one unit may require the Company to sell its shares to such holder so that the holder can raise its fractional ownership to a whole unit. These shares will be sold at (a) the closing price of the shares reported by the Tokyo Stock Exchange on the day when the request to sell becomes effective or (b) if no sale has taken place on the Tokyo Stock Exchange on that day, then the price at which sale of shares is effected on such stock exchange immediately thereafter. In such case, the Company will request payment of an amount equal to the brokerage commission applicable to the shares sold pursuant to its Regulations for Handling of Shares.
Voting Rights of a Holder of Shares Representing Less than One Unit
     A holder of shares representing less than one unit cannot exercise any voting rights pertaining to those shares. In calculating the quorum for various voting purposes, the aggregate number of shares representing less than one unit will be excluded from the number of outstanding shares. A holder of shares representing one or more whole units will have one vote for each whole unit represented.
     A holder of shares representing less than one unit does not have any rights relating to voting, such as the right to participate in a demand for the resignation of a director, the right to participate in a demand for the convocation of a general meeting of shareholders and the right to join with other shareholders to propose an agenda item to be addressed at a general meeting of shareholders. In addition, a holder of shares constituting less than one unit does not have the right to require the Company to issue share certificates for those shares.
     However, a holder of shares constituting less than one unit has all other rights of a shareholder in respect of those shares, including the following rights:
    to receive annual and interim dividends,
 
    to receive shares and/or cash by way of retirement, consolidation, subdivision, conversion, exchange or transfer of shares, company split or merger,
 
    to be allotted rights to subscribe for new shares and other securities when such rights are granted to shareholders,
 
    to participate in any distribution of surplus assets upon liquidation,
 
    to institute a representative action by shareholders, and
 
    to demand that a director suspend illegal and certain other acts.
Ordinary and Extraordinary General Meeting of Shareholders
     The Company normally holds its ordinary general meeting of shareholders in March of each year in Ohta-ku, Tokyo or in a neighbouring area. In addition, the Company may hold an extraordinary general meeting of shareholders whenever necessary by giving at least two weeks’ advance notice. Under the Commercial Code, notice of any shareholders’ meeting must be given to each shareholder having voting rights or, in the case of a non-resident shareholder, to his resident proxy or mailing address in Japan in accordance with the Company’s Regulations for Handling of Shares, at least two weeks prior to the date of the meeting.

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Voting Rights
     A shareholder is generally entitled to one vote per one unit of shares as described in this paragraph and under “Japanese Unit Share System” above. In general, under the Commercial Code, a resolution can be adopted at a general meeting of shareholders by a majority of the shares having voting rights represented at the meeting. The Commercial Code and the Company’s Articles of Incorporation require a quorum for the election of Directors and Corporate Auditors of not less than one-third of the total number of outstanding shares having voting rights. The Company’s shareholders are not entitled to cumulative voting in the election of Directors. A corporate shareholder whose outstanding shares are in turn more than one-quarter directly or indirectly owned by the Company does not have voting rights. Shareholders may exercise their voting rights through proxies, provided that those proxies are also shareholders who have voting rights.
     Pursuant to the Commercial Code and the Company’s Articles of Incorporation, a quorum of, not less than one-third of the outstanding shares with voting rights must be present at a shareholders’ meeting to approve any material corporate actions such as:
    a reduction of stated capital,
 
    amendment of the articles of incorporation (except amendments which the board of directors are authorized to make under the Commercial Code as described in “Stock Splits” and “Japanese Unit Share System” above),
 
    the removal of a director or corporate auditor,
 
    establishment of a 100% parent-subsidiary relationship by way of share exchange or share transfer,
 
    a dissolution, merger or consolidation,
 
    a corporate separation,
 
    the transfer of the whole or an important part of the Company’s business,
 
    the taking over of the whole of the business of any other corporation,
 
    any issuance of new shares at a “specially favourable” price, stock acquisition rights (shinkabu yoyakuken) with “specially favourable” conditions or bonds with stock acquisition rights (shinkabu yoyakuken-tsuki shasai) with “specially favourable” conditions to persons other than shareholders, and
 
    release of part of directors’ or corporate auditors’ liabilities to their corporation.

At least two-thirds of the outstanding shares having voting rights present at the meeting must approve these actions.

The voting rights of holders of ADSs are exercised by the depositary based on instructions from those holders.
Subscription Rights
     Holders of shares have no pre-emptive rights. Authorised but unissued shares may be issued at such times and upon such terms as the board of directors determines, subject to the limitations as to the issue of new shares at a “specially favourable” price mentioned in “Voting Rights” above. The board of directors may, however, determine that shareholders be given subscription rights to new shares, in which case they must be given on uniform terms to all shareholders as of a record date of which not less than two weeks’ prior public notice of the date on which such subscription rights must be given. Each of the shareholders to whom such rights are given must also be given at least two weeks’ prior notice of the date on which such rights will expire.
Stock Acquisition Rights
     The Company may issue stock acquisition rights or bonds with stock acquisition rights (in relation to which the stock acquisition rights are undetachable). Except where the issue would be on “specially favourable” conditions mentioned in “Voting Rights” above, the issue of stock acquisition rights or bonds with stock acquisition rights may be authorised by a resolution of the board of directors. Subject to the terms and conditions thereof, holders of stock acquisition rights may acquire a prescribed number of shares by exercising their stock acquisition rights and paying the exercise price at any time during the exercise period thereof. Upon exercise of stock acquisition rights, the Company will be obliged to either issue the relevant number of new shares or transfer the necessary number of existing shares held by it as treasury stock to the holder. The entitlements accorded to stock acquisition rights attached to bonds are substantially similar to those accorded to stock acquisition rights issued without being attached to bonds, provided that, if so determined by the board of directors at the time of its resolution authorising the issue of the relevant bonds with stock acquisition rights, then, upon exercise of the stock acquisition rights, their exercise price will be deemed to have been paid by the holder thereof to the Company in lieu of the Company redeeming the relevant bonds.
Liquidation Rights
     In the event of liquidation, the assets remaining after payment of all debts, liquidation expenses and taxes will be distributed among the shareholders in proportion to the number of shares they own.
Liability to Further Calls or Assessments
     All of the Company’s currently outstanding shares, including shares represented by the ADSs, are fully paid and nonassessable.

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Transfer Agent
     Mizuho Trust & Banking Co., Ltd. is the transfer agent for the Company’s shares. Mizuho Trust’s office is located at 2-1, Yaesu 1-chome, Chuo-ku, Tokyo, Japan. Mizuho Trust maintains the Company’s register of shareholders and records transfers of record ownership upon presentation of share certificates.
Record Date
     The close of business on December 31 is the record date for the Company’s year-end dividends, if paid. June 30 is the record date for interim dividends, if paid. A holder of shares constituting one or more whole units who is registered as a holder on the Company’s register of shareholders at the close of business as of December 31 is also entitled to exercise shareholders’ voting rights at the ordinary general meeting of shareholders with respect to the fiscal year ending on December 31. In addition, the Company may set a record date for determining the shareholders entitled to other rights and for other purposes by giving at least two weeks’ public notice.
     The shares generally trade ex-dividend or ex-rights in the Japanese stock exchanges on the third business day before a record date (or if the record date is not a business day, the fourth business day prior thereto), for the purpose of dividends or rights offerings.
Repurchase by the Company of Shares
     Under the Commercial Code, the Company may acquire its shares for any purposes subject to the authorization of shareholders at an ordinary general shareholders meeting. In addition, the Company is authorized to purchase its shares pursuant to a resolution of the board of directors pursuant to its Articles of Incorporation. The acquisition is subject to the condition that the aggregate amount of the purchase price must not exceed the amount of the retained earnings available for dividend payments less the sum of any amount paid or to be paid by way of appropriation of related earnings and any transfer of retained earnings to stated capital.
     In the case of shares listed on a Japanese stock exchange, acquisition shall be made through the market or by way of tender offer by the close of the following ordinary general meeting, unless acquisition of the shares from a specified person is authorized by the approval of two-thirds of outstanding shares having voting rights present at the shareholders’ meeting at which a quorum of at least one-third of the outstanding shares having voting rights must be present.
     In addition, the Company may acquire its shares by means of repurchase of any number of shares constituting less than one unit upon the request of the holder of those shares, as described under “Japanese Unit Share System” above.
     C. Material contracts
     All contracts entered into by us during the two years preceding the date of this annual report were entered into in the ordinary course of business.
     D. Exchange controls

  (a)   Information with respect to Japanese exchange regulations affecting the Company’s security holders is as follows:

         The Foreign Exchange and Foreign Trade Law of Japan, as amended and effective from April 1, 1998, and the cabinet orders and ministerial ordinances thereunder (the “Foreign Exchange Regulations”) govern certain aspects relating to the issuance of securities by the Company and the acquisition and holding of such securities by “non-residents of Japan” and by “foreign investors”, as hereinafter defined.
 
         “Non-residents of Japan” are defined as individuals who are not resident in Japan and corporations whose principal offices are located outside Japan. Generally, branches and other offices of Japanese corporations located outside Japan are regarded as non-residents of Japan, while branches and other offices located within Japan of non-resident corporations are regarded as residents of Japan. “Foreign investors” are defined to be (i) individuals not resident in Japan, (ii) corporations which are organized under the laws of foreign countries or whose principal offices are located outside Japan, (iii) corporations of which 50% or more of the shares are held by (i) and / or (ii) above and (iv) corporations in respect of which (a) a majority of the officers are non-resident individuals or (b) a majority of the officers having the power to represent the corporation are non-resident individuals.
 
    Issuance of Securities by the Company:
 
         Under the Foreign Exchange Regulations, the issue of securities outside Japan by the Company is, in principle, not subject to a prior notification requirement, but subject to a post reporting requirement of the Minister of Finance. Under the Foreign Exchange Regulations as currently in effect, payments of principal, premium and interest in respect of securities and any additional amounts payable pursuant to the terms thereof may in general be paid when made without any restrictions under the Foreign Exchange Regulations.
 
    Acquisition of Shares:
 
         In general, the acquisition of shares of stock of a Japanese company listed on any Japanese stock by a non-resident of Japan from a resident of Japan is not subject to a prior notification requirement, but subject to a post reporting requirement of the Minister of Finance by such resident.
 
         In the case where a foreign investor intends to acquire listed shares (whether from a resident or a non-resident of Japan, from another foreign investor or from or through a designated securities company) and as a result of such acquisition the number of shares held, directly or indirectly, by such foreign investor would become 10% or more of the total outstanding shares of the company, the foreign investor must generally report such acquisition to the Minister of Finance and other Ministers having jurisdiction over the business of the subject company within 15 days from and including the date of such acquisition. In certain exceptional cases, a prior notification is required in respect of such acquisition.

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Acquisition of Shares upon Exercise of Rights for Subscription of Shares:
     The acquisition by a non-resident of Japan of shares upon exercise of his rights for subscription of shares is exempted from the notification and reporting requirements described under “Acquisition of Shares” above.
Dividends and Proceeds of Sales:
  Under the Foreign Exchange Regulations currently in effect, dividends paid on, and the proceeds of sale in Japan of, the shares held by non-residents of Japan may be converted into any foreign currency and repatriated abroad. The acquisition of shares by non-resident shareholders by way of stock splits is not subject to any of the aforesaid notification requirements.
   (b) Reporting of Substantial Shareholdings:
     The Securities and Exchange Law of Japan requires any person who has become, beneficially and solely or jointly, a holder of more than 5% of the total outstanding voting shares of capital stock of a company listed on any Japanese stock exchange to file with the relevant Local Finance Bureau of the Minister of Finance within five business days a report concerning such share ownership. A similar report must also be made in respect of any subsequent change of 1% or more in any such holding. Copies of any such report must also be furnished to the issuer of such shares and all Japanese stock exchanges on which the shares are listed. For this purpose, shares issuable exercise of rights for subscription of shares held by such holder are taken into account in determining both the size of a holding and a company’s total outstanding share capital.
     E. Taxation
1. Taxation in Japan
     Generally, a non-resident of Japan or non-Japanese corporation ( “Non-Resident Holders”) is subject to Japanese withholding tax on dividends paid by Japanese corporations. Stock splits are not subject to Japanese income tax. Due to the 2001 Japanese tax legislation, a conversion of retained earnings or legal reserve (but, not additional paid-in capital, in general) into stated capital (whether made in connection with a stock split or otherwise) is no longer treated as a deemed dividend payment to shareholders for Japanese tax purposes. Thus, such a conversion does not trigger Japanese withholding taxation.
     Japan is party to a number of income tax treaties, conventions and agreements, (collectively “Tax Treaties”), whereby the maximum withholding tax rate for dividend payments is set at, in most cases, 15% for portfolio investors who are Non-Resident Holders. Specific countries with which such Tax Treaties have been entered into include Australia, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland and the United Kingdom. Pursuant to the new tax convention between the United States and Japan ratified in March 2004 (“New Tax Convention”), the withholding tax rate on dividends paid by a Japanese corporation to US residents or corporations is generally 10%, provided the recipients are portfolio investors who do not have a permanent establishment in Japan to which the shares with respect to which such dividends are paid are related and such recipients are qualified US residents eligible to enjoy treaty benefits. This 10% Japanese withholding tax rate is applicable from July 1, 2004 to dividends declared thereafter. Under the New Tax Convention, there is no withholding tax on dividends paid by Japanese Corporations to pension funds which are qualified U.S. residents eligible to enjoy benefits under the New Tax Conventions unless such dividends are derived from the carrying on of a business, directly or indirectly, by such pension funds. The 15% Japanese withholding tax rate under the old tax convention is still applicable to dividends declared before July 1, 2004. However, under the Japanese Income Tax Law, the temporary rate of Japanese withholding tax applicable to dividends paid with respect to listed shares, such as those paid by the Company, to Non-Resident Holders is currently 7% which is applicable for the period from January 1, 2004 to March 31, 2008 (15% rate(10% for eligible US residents) will apply thereafter), except for dividends paid to any individual shareholder who holds 5% or more of the total issued shares for which the applicable rate is 20%. While the treaty rate normally overrides the domestic rate, due to the so-called preservation doctrine, if the tax rate under the domestic tax law is lower than that promulgated under the applicable income tax treaty, then the domestic tax rate is still applicable. If the domestic tax rate applies, as will generally be the case until March 31, 2008 for most shareholders who are US residents or corporations, no treaty application is required to be filed.
2. Taxation in the United States
     The following is a discussion of material U.S. federal income tax consequences of purchasing, owning and disposing of Canon shares or ADSs to the persons described below, but it does not purport to be a comprehensive description of all of the tax considerations that may be relevant to a particular person’s decision to acquire, hold or dispose of such securities. The discussion applies only if you hold Canon shares or ADSs as capital assets for U.S. federal income tax purposes and it does not address special classes of holders, such as:
    certain financial institutions;
    insurance companies;
    dealers and traders in securities or foreign currencies;
    persons holding Canon shares or ADSs as part of a hedge, straddle, conversion or other integrated transaction;
    persons whose functional currency for U.S. federal income tax purposes is not the U.S. dollar;
    partnerships or other entities classified as partnerships for U.S. federal income tax purposes;
    persons liable for the alternative minimum tax;
    tax-exempt organizations;
    persons holding Canon shares or ADSs that own or are deemed to own 10% or more of any class of Canon stock; or
    persons who acquired Canon shares or ADSs pursuant to the exercise of any employee stock option or otherwise as compensation.

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     This discussion is based on the Internal Revenue Code of 1986, as amended, administrative pronouncements, judicial decision and final, temporary and proposed Treasury regulations, all as currently in effect. These laws are subject to change, possibly on a retroactive basis. It is also based in part on representations by the depositary and assumes that each obligation under the deposit agreement and any related agreement will be performed in accordance with its terms. Please consult your own tax advisers concerning the U.S. federal, state, local and foreign tax consequences of purchasing, owning and disposing of Canon shares or ADSs in your particular circumstances.
     The discussion below applies to you only if you are a beneficial owner of Canon shares or ADSs and are, for U.S. federal tax purposes:
    a citizen or resident of the United States;
    a corporation, or other entity taxable as a corporation, created or organized in or under the laws of the United States or any political subdivision thereof; or
    an estate or trust the income of which is subject to U.S. federal income taxation regardless of its source.
     In general, if you hold ADSs, you will be treated for U.S. federal income tax purposes as the holder of the underlying shares represented by those ADSs. Accordingly, no gain or loss will be recognized if you exchange ADSs for the underlying shares represented by those ADSs.
     The U.S. Treasury has expressed concerns that parties to whom ADSs are pre-released may be taking actions that are inconsistent with the claiming of foreign tax credits for U.S. holders of ADSs. Such actions would also be inconsistent with the claiming of the reduced rate of tax applicable to dividends received by certain non-corporate U.S. holders. Accordingly, the analysis of the creditability of Japanese taxes and the reduced rates of taxation applicable to dividends received by certain non-corporate U.S. holders, both as described below, could be affected by actions that may be taken by parties to whom ADSs are pre-released.
     This discussion assumes that Canon was not a passive foreign investment company for 2005, as described below.
Taxation of Distributions
     Distributions paid on Canon Shares or ADSs, other than certain pro rata distributions of common shares, to the extent paid out of Canon’s current or accumulated earnings and profits, as determined under U.S. federal income tax principles, will be treated as dividends. The amount of a dividend will include any amounts withheld by Canon or its paying agent in respect of Japanese taxes. The amount of the dividend will be treated as foreign-source dividend income to you and will not be eligible for the dividends-received deduction generally allowed to U.S. corporations. Subject to applicable limitations that may vary depending upon a U.S. holder’s individual circumstances and the concerns expressed by the U.S. Treasury, dividends paid to certain non-corporate holders in taxable years beginning before January 1, 2009 will be taxable at a maximum rate of 15%. Non-corporate U.S. holders should consult their own tax advisers to determine whether they are subject to any special rules that limit their ability to be taxed at this favorable rate.
     Dividends paid in Japanese yen will be included in your income in a U.S. dollar amount calculated by reference to the exchange rate in effect on the date of receipt of the dividend by you, in the case of Canon shares, or by the depository, in the case of ADSs, regardless of whether the payment is in fact converted into U.S. dollars. If the dividend is converted into U.S. dollars on the date of receipt, you generally should not be required to recognize foreign currency gain or loss in respect of the dividend income. You may have foreign currency gain or loss if you do not convert the amount of such dividend into U.S. dollars on the date of receipt.
     Japanese taxes withheld from cash dividends on Canon shares or ADSs will be creditable against your U.S. federal income tax liability, subject to applicable limitations that may vary depending upon your circumstances and the concerns expressed by the U.S. Treasury. Instead of claiming a credit, you may, at your election, deduct such Japanese taxes in computing your taxable income, subject to generally applicable limitations under U.S. law. The limitation on foreign taxes eligible for credit is calculated separately with respect to specific classes of income. You should consult your own tax adviser to determine whether you are subject to any special rules that limit your ability to make effective use of foreign tax credits.
Sale and Other Disposition of Canon Shares or ADSs
     For U.S. federal income tax purposes, gain or loss you realize on the sale or other disposition of Canon shares or ADSs will be capital gain or loss, and will be long-term capital gain or loss if you held the Canon shares or ADSs for more than one year. The amount of your gain or loss will be equal to the difference between your tax basis in the Canon shares or ADSs disposed of and the amount realized on the disposition. Such gain or loss will generally be U.S. source gain or loss for foreign tax credit purposes.
Passive Foreign Investment Company Rules
     Canon believes that it was not a passive foreign investment company (“PFIC”) for U.S. federal income tax purposes for 2005. However, since PFIC status depends upon the composition of Canon’s income and assets and the market value of its assets (including, among others, goodwill and equity investments in less than 25 % owned entities) from time to time, there can be no assurance that Canon will not be considered a PFIC for any taxable year. If Canon were treated as a PFIC for any taxable year during which you held Canon shares or ADSs, certain adverse taxconsequences could apply to you.
     If Canon were treated as a PFIC for any taxable year, gain recognized by you on the sale or other disposition of Canon shares or ADSs would be allocated ratably over you holding period for such securities. The amounts allocated to the taxable year of the sale or other disposition and to any year before Canon became a PFIC would be taxed as ordinary income. The amount allocated to each other taxable year would be subject to tax at the highest rate in effect for individuals or corporations, as appropriate, and an interest charge would be imposed on the tax liability attributable to such allocated amounts. Further, any distribution in respect of Canon shares or ADSs in excess of 125 % of the average of the annual distributions on such securities received by you during the preceding three years or your holding period, whichever is shorter, would be subject to taxation as described above. Certain elections (including a mark-to-market election) may be available to you that may mitigate the adverse tax consequences resulting from PFIC status.
     In addition, if Canon were treated as a PFIC in a taxable year in which it pays a dividend or the prior taxable year, the 15% dividend rate discussed above with respect to dividends paid to certain non-corporate U.S. holders would not apply.

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Information Reporting and Backup Withholding
     Payment of dividends and sales proceeds that are made within the United States or through certain U.S.-related financial intermediaries generally are subject to information reporting and to backup withholding unless you are a corporation or other exempt recipient or, in the case of backup withholding, you provide a correct taxpayer identification number and certify that no loss of exemption from backup withholding has occurred.
     The amount of any backup withholding from a payment to you will be allowed as a credit against your U.S. federal income tax liability and may entitle you to a refund, provided that the required information is furnished to the Internal Revenue Service.
     F. Dividends and paying agents
     Not applicable.
     G. Statement by experts
     Not applicable.
     H. Documents on display
     According to the Securities Exchange Act of 1934, as amended, the Company is subject to the requirements of informational disclosure. The Company files various reports and other information, including Form 20-F and Annual Reports, with the Securities Exchange Commission and the New York Stock Exchange. These reports may be inspected at the following sites.
     Securities Exchange Commission:
     450 Fifth Street, N.W., Washington D.C. 20549
     New York Stock Exchange:
     20 Broad Street, New York, New York 10005
     Form 20-F is also available at the Electronic Data Gathering, Analysis, Retrieval system (EDGAR) website which is maintained by the Securities Exchange Commission.
     Securities Exchange Commission Home Page:
     http://www.sec.gov
     I. Subsidiary information
     Not applicable.
Item 11. Quantitative and Qualitative Disclosures About Market Risk
Market risk exposures
     Canon is exposed to market risks, including changes in foreign currency exchange rates, interest rates and prices of marketable securities and investments. In order to hedge the risks of changes in foreign currency exchange rates and interest rates, Canon uses derivative financial instruments.

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Equity price risk
     Canon holds marketable securities included in current assets as short-term investments, which consists generally of highly-liquid and low-risk instruments. Investments included in noncurrent assets are held as long-term investments. Canon does not hold marketable securities and investments for trading purposes.
     Maturities and fair values of such marketable securities and investments were as follows at December 31, 2005 and 2004.
     Available-for-sale securities
                                 
    2005     2004  
    Cost     Fair value     Cost     Fair value  
    (Millions of yen)  
Due within one year
  ¥ 71     ¥ 71     ¥ 301     ¥ 341  
Due after one year through five years
    1,811       3,243       1,607       2,191  
Due after five years
    3,352       3,376       1,049       1,047  
Equity securities
    11,474       26,550       10,302       26,950  
 
                       
 
  ¥ 16,708     ¥ 33,240     ¥ 13,259     ¥ 30,529  
 
                       
     Held-to-maturity securities
                                 
    2005     2004  
    Cost     Fair value     Cost     Fair value  
    (Millions of yen)  
Due after one year through five years
  ¥ 20,961     ¥ 20,961     ¥ 21,460     ¥ 21,460  
 
                       
Foreign currency exchange rate and interest rate risk
     Canon operates internationally, exposing it to the risk of changes in foreign currency exchange rates and interest rates. Derivative financial instruments are comprised principally of foreign currency exchange contracts and interest rate swaps utilized by the Company and certain of its subsidiaries to reduce these risks. Canon assesses foreign currency exchange rate risk and interest rate risk by continually monitoring changes in these exposures and by evaluating hedging opportunities. Canon does not hold or issue derivative financial instruments for trading purposes. Canon is also exposed to credit-related losses in the event of non-performance by counterparties to derivative financial instruments, but it is not expected that any counterparties will fail to meet their obligations, because most of the counterparties are internationally recognized financial institutions and contracts are diversified across a number of major financial institutions.
     Canon’s international operations expose Canon to the risk of changes in foreign currency exchange rates. Canon uses foreign exchange contracts to manage certain foreign currency exchange exposures principally from the exchange of U.S. dollar and euro into Japanese yen. These contracts are primarily used to hedge the foreign currency exposure of forecasted intercompany sales and intercompany trade receivables which are denominated in foreign currencies. In accordance with Canon’s policy, a specific portion of foreign currency exposure resulting from forecasted intercompany sales are hedged using foreign exchange contracts which principally mature within three months.
     The following table provides information about Canon’s major derivative financial instruments related to foreign currency exchange transactions existing at December 31, 2005. All of the foreign exchange contracts described in the following table have a contractual maturity date in 2006.
                                 
    Millions of yen  
    U.S.$     euro     Others     Total  
Forwards to sell foreign currencies:
                               
Contract amounts
  ¥ 361,072       251,195       32,921       645,188  
Estimated fair value
    (4,829 )     (1,459 )     (352 )     (6,640 )
Forwards to buy foreign currencies:
                               
Contract amounts
  ¥ 30,033       5,974       10,417       46,424  
Estimated fair value
    17       (296 )     (893 )     (1,172 )
     Canon’s exposure to the risk of changes in interest rates relates primarily to its debt obligations. The variable-rate debt obligations expose Canon to variability in their cash flows due to change in interest rates. To manage the variability in cash flows caused by interest rate changes, Canon enters into interest rate swaps when it is determined to be appropriate based on market conditions. The interest rate swaps change variable-rate debt obligations to fixed-rate debt obligations by primarily entering into pay-fixed, receive-variable interest rate swaps.

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     Derivative financial instruments designated as fair value hedges principally relate to interest rate swaps associated with fixed-rate debt obligations. Changes in fair values of the hedged debt obligations and derivative instruments designated as fair value hedges of these debt obligations are recognized in other income (deductions). There is no hedging ineffectiveness or net gains or losses excluded from the assessment of hedge effectiveness for fiscal 2004 and 2003 as the critical terms of the interest rate swaps match the terms of the hedged debt obligations. Canon had no fair value hedges in 2005.
     Changes in the fair value of derivative financial instruments designated as cash flow hedges, including foreign exchange contracts associated with forecasted intercompany sales and interest rate swaps associated with variable rate debt obligations, are reported in accumulated other comprehensive income (loss). These amounts are subsequently reclassified into earnings through other income (deductions) in the same period as the hedged items affect earnings. Substantially all amounts recorded in accumulated other comprehensive income (loss) at year-end are expected to be recognized in earnings over the next twelve months. Canon excludes the time value component from the assessment of hedge effectiveness.
     The amounts of the hedging ineffectiveness are not material for the years ended December 31, 2005, 2004 and 2003. The amounts of net gains or losses excluded from the assessment of hedge effectiveness which are recorded in other income (deductions) are net losses of Yen 3,725 million, Yen 2,096 million and Yen 490 million for the years ended December 31, 2005, 2004 and 2003, respectively.
     Canon has entered into certain foreign currency exchange contracts to manage its foreign currency exposures. These foreign currency exchange contracts have not been designated as hedges. Accordingly, the changes in fair values of the contracts are recorded in earnings immediately.
     For debt obligations, the table below presents principal cash flows by expected maturity dates and related weighted average interest rates, as of December 31, 2005 and 2004.
Long-term debt (including due within one year)
                                                                         
    Weighted Average             Expected maturity date  
    interest                                                             Estimated  
    rates*     Total     2006     2007     2008     2009     2010     Thereafter     fair value  
            (Millions of yen except interest rate data)  
Year ended December 31, 2005:
                                                                       
Japanese yen notes
    2.61 %   ¥ 20,000           ¥ 10,000     ¥ 10,000                       ¥ 20,848  
Japanese yen convertible debentures
    1.30       649                   649                         3,052  
Other long-term debt
    2.40       11,425     ¥ 4,992       3,318       1,702     ¥ 895     ¥ 417     ¥ 101       11,294  
 
                                                       
Total
          ¥ 32,074     ¥ 4,992     ¥ 13,318     ¥ 12,351     ¥ 895     ¥ 417     ¥ 101     ¥ 35,194  
 
                                                     
                                                                         
    Weighted Average             Expected maturity date  
    interest                                                             Estimated  
    rates*     Total     2005     2006     2007     2008     2009     Thereafter     fair value  
            (Millions of yen except interest rate data)  
Year ended December 31, 2004:
                                                                     
Japanese yen notes
    2.46 %   ¥ 25,200     ¥ 5,200           ¥ 10,000     ¥ 10,000                 ¥ 26,559  
Japanese yen convertible debentures
    1.28       1,796       309                   1,487                   6,634  
Other long-term debt
    2.38       11,534       4,370     ¥ 5,046       1,401       587     ¥ 105     ¥ 25       11,427  
 
                                                       
Total
          ¥ 38,530     ¥ 9,879     ¥ 5,046     ¥ 11,401     ¥ 12,074     ¥ 105     ¥ 25     ¥ 44,620  
 
                                                     
Note:  All long-term debt as of December 31, 2005, is fixed rate debt. All long-term debt as of December 31, 2004, is fixed rate debt except loans, principally from banks which include both fixed and floating rate debt.
Item 12. Description of Securities Other than Equity Securities
     Not applicable.

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PART II
Item 13. Defaults, Dividend Arrearages and Delinquencies
     None.
Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds
     As a result of amendments to the Japanese Commercial Code which became effective on October 1, 1982 (the “1982 Amendments”), the Deposit Agreement dated May 1, 1969, which constituted the American Depositary Receipts for 10,000,000 ADSs, each ADS representing five shares, was amended and restated as of October 1, 1982 (the “amended Deposit Agreement”).
     Under the 1982 Amendments, the Company was required to adopt a “unit” of shares (“tan-i-kabu”). At its annual meeting of shareholders held on March 30, 1982, the Company adopted 1,000 shares as one unit, effective from October 1, 1982.
     Recent amendments to the Japanese Commercial Code abolished the unit share system called “tan-i-kabu” as of October 1, 2001, and introduced a new unit share system called “tangen-kabu” (together with the 1982 Amendments, the “Amendments”). Pursuant to these legal changes, the Company was deemed to have amended its Articles of Incorporation in October 2001, so that 1,000 shares constituted one new unit. The Commercial Code permits the Board of Directors to reduce the number of shares that will constitute a new unit or abolish the new unit share system entirety by amending the Company’s Articles of Incorporation without approval by shareholders. The Board of Directors of the Company resolved to reduce the number of shares per unit to 100 shares and its Articles of Incorporation has been amended accordingly. The number of shares constituting a new unit may not exceed 1,000 shares or one-two hundredths (1/200) of the number of all issued shares.
     Under the unit share system, shareholders have one voting right for each unit of shares they hold. Shares not constituting a full unit will carry all shareholders’ rights except for those relating to voting rights.
     Pursuant to the Amendments, the Company is deemed to have amended its Articles of Incorporation so that no share certificates will be issued with respect to any shares constituting less than one unit. Consequently, no certificates for shares other than a full unit or an integral multiple thereof will be issued unless the Company determines that it is necessary to issue such certificates for protection of the holders of shares constituting less than one unit. As the transfer of shares normally requires delivery of the relevant share certificates, any fraction of a unit for which no share certificates are issued will not be transferable.
     A holder of shares constituting less than one unit may at any time require the Company (through the participating institution in the case of a beneficial shareholder under the central clearing system) to purchase such shares at the last selling price of a share as reported by the Tokyo Stock Exchange, Inc. on the day when such request is made.
     Shareholders (including beneficial owners) who own less than one unit of shares may request that Company sell them a number of shares which, when added to their less than one unit shares, would equal one unit of shares; provided, however, that the Company is not obliged to do so if the Company does not own its own shares in the number which it is requested to sell.
     A holder of shares constituting less than one unit is entitled as a shareholder to the rights (i) to receive distribution of dividends of profit or interest, (ii) to receive shares and/or cash by way of retirement, consolidation, division, conversion, exchange or transfer of shares, company split or merger, (iii) to be allotted rights to subscribe for new shares and other securities when such rights are granted to shareholders; and (iv) to participate in any distribution of surplus assets upon liquidation. Such holder cannot exercise any voting rights pertaining to those shares. For calculation of the quorum for various voting purposes, the aggregate number of shares constituting less than one unit will be excluded from the number of voting rights.
     As a result of the Amendments, the depositary under the Deposit Agreement may be unable to deliver share certificates with respect to those shares otherwise deliverable upon the surrender of ADRs which do not constitute one or more complete units. In such case, the amended Deposit Agreement provides that the depositary will promptly advise the holder of the amount of such shares, deliver to the holder a new ADR evidencing such shares, and notify the holder of the additional amount of ADRs which the holder must surrender in order for the depositary to effect delivery of share certificates for all of shares represented by the holder’s ADSs.
     Effective from March 16, 1998, the Company changed the ratio of ADSs to shares from five shares to one share. In this regard, four additional ADSs for each ADS held were distributed to holders of ADS. Existing ADRs remain valid and do not need to be exchanged for new ones.

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Item 15. Controls and Procedures
Evaluation of disclosure controls and procedures
     As of December 31, 2005, Canon, under the supervision and with the participation of its management, including the chief executive officer and the chief financial officer, performed an evaluation of the effectiveness of its disclosure controls and procedures. Canon’s management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which by their nature can provide only reasonable assurance regarding management’s control objectives. Based on this evaluation, Canon’s chief executive officer and chief financial officer concluded that Canon’s disclosure controls and procedures are effective at the reasonable assurance level for gathering, analyzing and disclosing the information Canon is required to disclose in the reports it files under the Securities Exchange Act of 1934, within the time periods specified in the SEC’s rules and forms.
Changes in internal controls over financial reporting
     There has been no change in Canon’s internal control over financial reporting that occurred during the period covered by this Annual Report that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.
Item 16A. Audit Committee Financial Expert
     Canon’s Board of Directors has determined that Kunihiro Nagata qualifies as an “audit committee financial expert” as defined by the rules of the SEC. Mr. Nagata began his career at Canon in 1970, and since that time has worked in the field of finance and accounting for nearly thirty years. From 1996 to 1999, Mr. Nagata served as a senior manager of the Accounting Planning & Administration Division, the division responsible for Canon’s consolidated reporting. Mr. Nagata was elected as one of Canon’s corporate auditors at an ordinary general meeting of shareholders held in March 2004. See Item 6.A. for additional information regarding Mr. Nagata.
Item 16B. Code of Ethics
     Canon maintains a “Canon Group Code of Conduct”, or Code of Conduct, applicable to all executives and employees. The Code of Conduct sets forth provisions relating to honest and ethical conduct (including the handling of conflicts of interest), compliance with applicable laws, rules and regulations and accountability for adherence to the provisions of the Code of Conduct. In addition, on March 31, 2004, the Board of Directors adopted a “Code of Ethics” as a supplement to the Code of Conduct. This Code of Ethics applies to Canon’s President and Chief Executive Officer, each member of the Board of Directors (which includes the Chief Financial Officer) and general managers belonging to Canon’s accounting headquarters. The Code of Ethics requires full, fair, accurate, timely and understandable disclosure in reports and documents that Canon files with or submits to the SEC and in Canon’s other communications with the public, prompt internal reporting of violations of the Code of Conduct or Code of Ethics, and accountability for adherence to their provisions. Both the Code of Conduct and the Code of Ethics have been filed as exhibits to this Annual Report.
Item 16C. Principal Accountant Fees and Services
Policy on Pre-Approval of Audit and Non-Audit Services of Independent Auditors
     Canon’s board of corporate auditors consisting of five members, including three outside corporate auditors, is responsible for the oversight of the services of independent auditors. The board of corporate auditors has established Pre-Approval Policies and Procedures for Audit and Non-Audit Services, effective as of May 28, 2003. These policies and procedures govern the board of corporate auditors’ review and approval of the board of director’s engagement of Canon’s external auditors to render audit or non-audit services. Non-audit services include audit-related services, tax services and other services, as described in greater detail below under “Fees and Services”. Canon and any affiliate controlled by Canon directly, indirectly or through one or more intermediaries must follow these policies and procedures before any engagement of Canon’s independent accountants for U.S. securities law reporting purposes.
     The policies and procedures stipulate three means by which audit and non-audit services may be pre-approved, depending on the content of and the fee for the services.
  All services provided to Canon necessary to perform an annual or semi-annual audit or review to comply with the standards of the Public Company Accounting Oversight Board (United States), in any jurisdiction, including tax services and accounting consultation necessary to comply with the standards of the Public Company Accounting Oversight Board (United States) in those jurisdictions, and any engagement of an Independent Registered Public Accounting Firm for any audit or non-audit service involving estimated fees exceeding Yen 10,000,000 per single engagement must be approved by the full board of corporate auditors.
 
  Certain other services may be pre-approved under detailed categories of audit and non-audit services established annually by the board of corporate auditors, as long as those services do not exceed specified maximum yen limits for aggregate fees relating to each of those categories. Any engagement of an Independent Registered Public Accounting Firm by these means must be reported to the board of corporate auditors at its next regularly scheduled meeting.
 
  For services that are not covered by the above two means of pre-approval, the board of corporate auditors has delegated pre-approval authority to the Chairman of the board of corporate auditors. Any engagement of an Independent Registered Public Accounting Firm by the Chairman is required to be reported to the board of corporate auditors at its next regularly scheduled meeting.

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Additional services may be pre-approved by the board of corporate auditors on an individual basis.

     No services were provided for which pre-approval was waived pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation S-X.

Fees and Services.

     The following table discloses the aggregate fees accrued or paid to Canon’s principal accountant for each of the last two fiscal years and briefly describes the services performed:

                 
    Year ended
December 31, 2005
    Year ended
December 31, 2004
 
    (Millions of yen)
Audit fees
  ¥ 968     ¥ 690  
Audit-related fees
    439       74  
Tax fees
    49       32  
All other fees
    92       90  
 
           
Total
  ¥ 1,548     ¥ 886  
 
           

  Audit fees include fees billed for professional services rendered for audits of Canon’s annual consolidated financial statements, review of consolidated quarterly financial statements, statutory audits of the Company and its subsidiaries.
 
  Audit-related fees include fees billed for assurance and related services such as due diligence, accounting consultations and audits in connection with mergers and acquisitions, employee benefit plan audits, internal control reviews, and consultations concerning financial accounting and reporting standards.
 
  Tax fees include fees billed for services related to tax compliance, including the preparation of tax returns and claims for refund, tax planning and tax advice, including assistance with tax audits and appeals, advice related to mergers and acquisitions, tax services for employee benefit plans and assistance with respect to requests for rulings from tax authorities.
 
  All other fees include fees billed primarily for services rendered with respect to learning products and services.
 
  Ernst & Young ShinNihon served as Canon’s principal accountant for fiscal 2005 and 2004.

Item 16D. Exemptions from the Listing Standards for Audit Committees
     Canon is relying on the general exemption contained in Rule 10A-3(c)(3) under the Exchange Act. Because of such reliance, Canon does not have an audit committee which can act independently and satisfy the other requirements of Rule 10A-3 under the Exchange Act.
     According to Rule 10A-3 under the Exchange Act and NYSE listing standards, Canon’s board of corporate auditors has been identified to act in place of an audit committee. The board of corporate auditors meets the following requirements of the general exemption contained in Rule 10A-3(c)(3):

  the board of corporate auditors is established pursuant to applicable Japanese law and Canon’s Articles of Incorporations;
  under Japanese legal requirements, the board of corporate auditors is separate from the board of directors;
  the board of corporate auditors is not elected by the management of Canon and no executive officer of Canon is a member of the board of corporate auditors;  
  all of the members of the board of corporate auditors meet specific independence requirements from Canon and the Canon Group, the management and the auditing firm, as set forth by Japanese legal provisions;
  the board of corporate auditors, in accordance with and to the extent permitted by Japanese law, is responsible for the appointment, retention and oversight of the work of Canon’s external auditors engaged for the purpose of issuing audit reports on Canon’s annual financial statements;
  the board of corporate auditors adopted a complaints procedure (which became effective prior to July 31, 2005) in accordance with Rule 10A-3(b)(3) of the Exchange Act;
  the board of corporate auditors is authorized to engage independent counsel and other advisers, as it deems appropriate; and  
  the board of corporate auditors is provided for appropriate funding for payment of (i) compensation to Canon’s external auditors engaged for the purpose of issuing audit reports on Canon’s annual financial statements, (ii) compensation to independent counsel and other advisers engaged by the board of corporate auditors, and (iii) ordinary administrative expenses of the board of corporate auditors in carrying out its duties.  

     Canon’s reliance on Rule 10A-3(c)(3) does not, in its opinion, materially adversely affect the ability of its board of corporate auditors to act independently and to satisfy the other requirements of Rule 10A-3.

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Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers
     The following table sets forth, for each of the months indicated, the total number of shares purchased by us or on our behalf or any affiliated purchaser, the average price paid per share, the number of shares purchased as part of a publicly announced repurchase plan or program, the maximum number of shares or approximate Japanese Yen value that may yet be purchased under the plans or programs.
                                 
    (a) Total Number of     (b) Average Price     (c) Total Numbers of     (d) Maximum Numbers  
    Shares Purchased     Paid per Share     Shares Purchased as     of Shares that May  
                    Part of Publicly     Yet Be Purchased  
                    Announced Plans or     Under the Plans or  
    (Shares)     (Yen)     Programs     Programs  
January 1 - January 31
    1,938       5,418              
February 1 - February 28
    2,853       5,455              
March 1 - March 31
    1,614       5,558              
April 1 - April 30
    2,528       5,736              
May 1 - May 31
    1,658       5,641              
June 1 - June 30
    2,867       5,909              
July 1 - July 31
    1,986       5,959              
August 1 - August 31
    1,100       5,610              
September 1 - September 30
    2,776       5,675              
October 1 - October 31
    3,488       6,167              
November 1 - November 30
    1,491       6,450              
December 1 - December 31
    1,861       6,963              
     Canon currently does not have any publicly announced repurchase plans or programs. All of the purchase shown above represent with the purchase of fractional shares from fractional share owners, in accordance with the Japanese Commercial Code.

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PART III
Item 17. Financial Statements
         
Consolidated financial statement of Canon Inc. and Subsidiaries:   Page number  
 
       
Report of Ernst & Young ShinNihon, Independent Registered Public Accounting Firm
    65  
 
       
Report of KPMG AZSA & Co., Independent Registered Public Accounting Firm
    66  
 
       
Consolidated Balance Sheets as of December 31, 2005 and 2004
    67  
 
       
Consolidated Statements of Income for the years ended December 31, 2005, 2004 and 2003
    68  
 
       
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2005, 2004 and 2003
    69  
 
       
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003
    70  
 
       
Notes to Consolidated Financial Statements
    71  
 
       
Schedule:
       
 
       
Schedule II Valuation and Qualifying Accounts for the years ended December 31, 2005, 2004 and 2003
    114  
     All other schedules are omitted as permitted by the rules and regulations of the Securities and Exchange Commission as not applicable.

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Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
Canon Inc.
We have audited the accompanying consolidated balance sheets of Canon Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2005, all expressed in Japanese yen. Our audits also included the financial statement schedule listed in the Index at Item 17 for each of the two years in the period ended December 31, 2005. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule 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. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The Company’s consolidated financial statements do not disclose segment information required by Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information.” In our opinion, disclosure of segment information is required by U.S. generally accepted accounting principles.
In our opinion, except for the omission of segment information as discussed in the preceding paragraph, the 2005 and 2004 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Canon Inc. and subsidiaries at December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 2005 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule for each of the two years in the period ended December 31, 2005, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ Ernst & Young ShinNihon
Tokyo, Japan
January 26, 2006

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Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Canon Inc.:
We have audited the accompanying consolidated statements of income, stockholders’ equity and cash flows (expressed in yen) of Canon Inc. and subsidiaries for the year ended December 31, 2003. In connection with our audit of the consolidated financial statements, we also have audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule 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 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 audit provides a reasonable basis for our opinion.
The Company’s consolidated financial statements do not disclose certain information required by Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information”. In our opinion, disclosure of this information is required by U.S. generally accepted accounting principles.
In our opinion, except for the omission of the segment information as discussed in the preceding paragraph, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and the cash flows of Canon Inc. and subsidiaries for the year ended December 31, 2003, in conformity with U.S. generally accepted accounting principles.
Also in our opinion, the 2003 related financial statement schedule, when considered in relation to the 2003 basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ KPMG AZSA & Co.
Tokyo, Japan
January 28, 2004

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Canon Inc. and Subsidiaries
Consolidated Balance Sheets
                 
    December 31  
    2005     2004  
    (Millions of yen)  
Assets
               
Current assets:
               
Cash and cash equivalents
  ¥ 1,004,953     ¥ 887,774  
Marketable securities (Note 3)
    172       1,554  
Trade receivables, net (Note 4)
    689,427       602,790  
Inventories (Note 5)
    510,195       489,128  
Prepaid expenses and other current assets (Notes 7 and 13)
    253,822       250,906  
 
           
Total current assets
    2,458,569       2,232,152  
Noncurrent receivables (Note 19)
    14,122       14,567  
Investments (Notes 3 and 10)
    104,486       97,461  
Property, plant and equipment, net (Notes 6, 7 and 10)
    1,148,821       961,714  
Other assets (Notes 7, 8, 9, 12 and 13)
    317,555       281,127  
 
           
Total assets
  ¥ 4,043,553     ¥ 3,587,021  
 
           
Liabilities and stockholders’ equity
               
Current liabilities:
               
Short-term loans and current portion of long-term debt (Note 10)
  ¥ 5,059     ¥ 9,879  
Trade payables (Note 11)
    505,126       465,396  
Income taxes (Note 13)
    110,844       105,565  
Accrued expenses (Note 19)
    248,205       205,296  
Other current liabilities (Note 13)
    209,394       197,029  
 
           
Total current liabilities
    1,078,628       983,165  
Long-term debt, excluding current installments (Note 10)
    27,082       28,651  
Accrued pension and severance cost (Note 12)
    80,430       132,522  
Other noncurrent liabilities (Note 13)
    52,395       45,993  
 
           
Total liabilities
    1,238,535       1,190,331  
 
               
Minority interests
    200,336       186,794  
 
               
Commitments and contingent liabilities (Note 19)
               
 
               
Stockholders’ equity:
               
Common stock
               
Authorized 2,000,000,000 shares;
issued 888,742,779 shares in 2005 and 887,977,251 shares in 2004 (Note 14)
    174,438       173,864  
Additional paid-in capital (Note 14)
    403,246       401,773  
Legal reserve (Note 15)
    42,331       41,200  
Retained earnings (Note 15)
    2,018,289       1,699,634  
Accumulated other comprehensive income (loss) (Note 16)
    (28,212 )     (101,312 )
Treasury stock, at cost 1,145,682 shares in 2005 and 1,120,867 shares in 2004
    (5,410 )     (5,263 )
 
           
Total stockholders’ equity
    2,604,682       2,209,896  
 
           
Total liabilities and stockholders’ equity
  ¥ 4,043,553     ¥ 3,587,021  
 
           
See accompanying notes to consolidated financial statements.

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Canon Inc. and Subsidiaries
Consolidated Statements of Income
                         
    Year ended December 31  
    2005     2004     2003  
    (Millions of yen)  
Net sales
  ¥ 3,754,191     ¥ 3,467,853     ¥ 3,198,072  
Cost of sales (Notes 9, 12 and 19)
    1,935,148       1,754,510       1,589,172  
 
                 
Gross profit
    1,819,043       1,713,343       1,608,900  
 
                       
Selling, general and administrative expenses (Notes 1, 9, 12 and 19)
    949,524       894,250       895,336  
Research and development expenses
    286,476       275,300       259,140  
 
                 
Operating profit
    583,043       543,793       454,424  
 
                       
Other income (deductions):
                       
Interest and dividend income
    14,252       7,118       9,284  
Interest expense
    (1,741 )     (2,756 )     (4,627 )
Other, net (Notes 1, 3 and 18)
    16,450       3,961       (10,911 )
 
                 
 
    28,961       8,323       (6,254 )
 
                 
Income before income taxes and minority interests
    612,004       552,116       448,170  
Income taxes (Note 13)
    212,785       194,014       162,653  
 
                 
Income before minority interests
    399,219       358,102       285,517  
Minority interests
    15,123       14,758       9,787  
 
                 
Net income
  ¥ 384,096     ¥ 343,344     ¥ 275,730  
 
                 
 
                       
   
(Yen)
     
Net income per share (Note 17):
                       
Basic
  ¥ 432.94     ¥ 387.80     ¥ 313.81  
Diluted
    432.55       386.78       310.75  
Cash dividends per share
    100.00       65.00       50.00  
See accompanying notes to consolidated financial statements.

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Canon Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity
                         
    Year ended December 31  
    2005     2004     2003  
    (Millions of yen)  
Common stock:
                       
Balance at beginning of year
  ¥ 173,864     ¥ 168,892     ¥ 167,242  
Conversion of convertible debt
    574       4,972       1,650  
 
                 
Balance at end of year
    174,438       173,864       168,892  
Additional paid-in capital:
                       
Balance at beginning of year
    401,773       396,939       394,088  
Conversion of convertible debt and other
    574       4,966       1,649  
Stock exchanged under exchange offering
          114        
Capital transactions by consolidated subsidiaries and affiliated companies
    899       (246 )     1,202  
 
                 
Balance at end of year
    403,246       401,773       396,939  
Legal reserve:
                       
Balance at beginning of year
    41,200       39,998       38,803  
Transfers from retained earnings
    1,131       1,202       1,195  
 
                 
Balance at end of year
    42,331       41,200       39,998  
Retained earnings:
                       
Balance at beginning of year
    1,699,634       1,410,442       1,164,445  
Net income for the year
    384,096       343,344       275,730  
Cash dividends
    (64,310 )     (52,950 )     (28,538 )
Transfers to legal reserve
    (1,131 )     (1,202 )     (1,195 )
 
                 
Balance at end of year
    2,018,289       1,699,634       1,410,442  
Accumulated other comprehensive income (loss):
                       
Balance at beginning of year
    (101,312 )     (143,275 )     (166,467 )
Other comprehensive income (loss) for the year, net of tax
    73,100       41,963       23,192  
 
                 
Balance at end of year
    (28,212 )     (101,312 )     (143,275 )
Treasury stock:
                       
Balance at beginning of year
    (5,263 )     (7,451 )     (6,161 )
Repurchase, net
    (147 )     (503 )     (1,290 )
Stock exchanged under exchange offering
          2,691        
 
                 
Balance at end of year
    (5,410 )     (5,263 )     (7,451 )
 
                 
Total stockholders’ equity
  ¥ 2,604,682     ¥ 2,209,896     ¥ 1,865,545  
 
                 
Disclosure of comprehensive income:
                       
Net income for the year
  ¥ 384,096     ¥ 343,344     ¥ 275,730  
Other comprehensive income (loss) for the year, net of tax (Note 16):
                       
Foreign currency translation adjustments
    53,979       4,050       (15,277 )
Net unrealized gains and losses on securities
    (1,397 )     686       7,952  
Net gains and losses on derivative instruments
    (481 )     (396 )     37  
Minimum pension liability adjustments
    20,999       37,623       30,480  
 
                 
Other comprehensive income (loss)
    73,100       41,963       23,192  
 
                 
Total comprehensive income for the year
  ¥ 457,196     ¥ 385,307     ¥ 298,922  
 
                 
See accompanying notes to consolidated financial statements.

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Canon Inc. and Subsidiaries
Consolidated Statements of Cash Flows
                         
    Year ended December 31  
    2005     2004     2003  
    (Millions of yen)  
Cash flows from operating activities:
                       
Net income
  ¥ 384,096     ¥ 343,344     ¥ 275,730  
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Depreciation and amortization
    225,941       192,692       183,604  
Loss on disposal of property, plant and equipment
    13,784       24,597       12,639  
Deferred income taxes
    (766 )     9,060       (3,035 )
Increase in trade receivables
    (48,391 )     (53,595 )     (36,638 )
(Increase) decrease in inventories
    27,558       (40,050 )     (15,823 )
Increase in trade payables
    16,018       65,873       1,129  
Increase in income taxes
    1,998       21,689       3,441  
Increase in accrued expenses
    31,241       8,196       37,131  
Increase (decrease) in accrued pension and severance cost
    (16,221 )     (16,924 )     29,445  
Other, net
    (29,580 )     6,647       (21,974 )
 
                 
Net cash provided by operating activities
    605,678       561,529       465,649  
 
                       
Cash flows from investing activities:
                       
Purchases of fixed assets
    (395,055 )     (256,714 )     (199,720 )
Proceeds from sale of fixed assets
    14,827       7,431       9,354  
Purchases of available-for-sale securities
    (5,680 )     (388 )     (249 )
Purchases of held-to-maturity securities
          (21,544 )      
Proceeds from sale of available-for-sale securities
    12,337       9,735       6,544  
Acquisitions of subsidiaries, net of cash acquired
    (17,657 )            
Proceeds from sale of subsidiary common stock
          9,731        
Purchases of other investments
    (19,531 )     (8,628 )     (24,341 )
Other, net
    9,618       7,410       8,464  
 
                 
Net cash used in investing activities
    (401,141 )     (252,967 )     (199,948 )
 
                       
Cash flows from financing activities:
                       
Proceeds from issuance of long-term debt
    1,716       2,115       4,132  
Repayments of long-term debt
    (15,187 )     (43,175 )     (25,301 )
Decrease in short-term loans
    (12,011 )     (3,046 )     (49,224 )
Dividends paid
    (64,310 )     (52,950 )     (28,538 )
Purchases of treasury stock, net
    (147 )     (494 )     (1,071 )
Other, net
    (4,000 )     (4,718 )     (2,037 )
 
                 
Net cash used in financing activities
    (93,939 )     (102,268 )     (102,039 )
 
                       
Effect of exchange rate changes on cash and cash equivalents
    6,581       (8,818 )     5,365  
 
                 
Net increase in cash and cash equivalents
    117,179       197,476       169,027  
Cash and cash equivalents at beginning of year
    887,774       690,298       521,271  
 
                 
Cash and cash equivalents at end of year
  ¥ 1,004,953     ¥ 887,774     ¥ 690,298  
 
                 
 
                       
Supplemental disclosure for cash flow information (Note 21):
                       
Cash paid during the year for:
                       
Interest
  ¥ 1,919     ¥ 2,981     ¥ 4,570  
Income taxes
    211,540       164,450       162,247  
See accompanying notes to consolidated financial statements.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements
1.   Basis of Presentation and Significant Accounting Policies
 
(a)   Description of Business
 
    Canon Inc. (the “Company”) and subsidiaries (collectively “Canon”) is one of the world’s leading manufacturers in such fields as office imaging products, computer peripherals, business information products, cameras, and optical related products. Office imaging products consist mainly of copying machines and digital multifunction devices. Computer peripherals consist mainly of laser beam and inkjet printers. Business information products consist mainly of computer information systems, micrographics and calculators. Cameras consist mainly of single lens reflex (“SLR”) cameras, compact cameras, digital cameras and video camcorders. Optical related products include steppers and aligners used in semiconductor chip production, projection aligners used in the production of liquid crystal displays (“LCDs”), broadcasting lenses and medical equipment. Canon’s consolidated net sales for the years ended December 31, 2005, 2004 and 2003 were distributed as follows: office imaging products 31%, 33% and 34%, computer peripherals 33%, 33% and 34%, business information products 3%, 3% and 4%, cameras 23%, 22% and 20%, and optical and other products 10%, 9% and 8%, respectively.
 
    Sales are made principally under the Canon brand name, almost entirely through sales subsidiaries. These subsidiaries are responsible for marketing and distribution, and primarily sell to retail dealers in their geographical area. Approximately 74%, 73% and 73% of consolidated net sales for the years ended December 31, 2005, 2004 and 2003 were generated outside Japan, with 30%, 30% and 33% in the Americas, 32%, 31% and 30% in Europe, and 12%, 12% and 10% in other areas, respectively.
 
    Canon sells laser beam printers on an OEM basis to Hewlett-Packard Company; such sales constituted approximately 21%, 21% and 20% of consolidated net sales for the years ended December 31, 2005, 2004 and 2003, respectively.
 
    Canon’s manufacturing operations are conducted primarily at 23 plants in Japan and 17 overseas plants which are located in countries or regions such as the United States, Germany, France, Taiwan, China, Malaysia, Thailand and Vietnam.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(b)   Basis of Presentation
 
    The Company and its domestic subsidiaries maintain their books of account in conformity with financial accounting standards of Japan. Foreign subsidiaries maintain their books of account in conformity with financial accounting standards of the countries of their domicile.
 
    Certain adjustments and reclassifications have been incorporated in the accompanying consolidated financial statements to conform with U.S. generally accepted accounting principles. These adjustments were not recorded in the statutory books of account.
 
(c)   Principles of Consolidation
 
    The consolidated financial statements include the accounts of the Company, its majority owned subsidiaries and those variable interest entities where the Company is the primary beneficiary under FASB Interpretation No. 46 (revised December 2003) (“FIN 46R”), “Consolidation of Variable Interest Entities.” All significant intercompany balances and transactions have been eliminated.
 
(d)   Use of Estimates
 
    The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Significant estimates and assumptions are reflected in valuation and disclosure of revenue recognition, allowance for doubtful receivables, valuation of inventories, environmental liabilities, valuation of deferred tax assets and employee retirement and severance benefit plans. Actual results could differ materially from those estimates.
 
(e)   Cash Equivalents
 
    All highly liquid investments acquired with an original maturity of three months or less are considered to be cash equivalents.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(f)   Translation of Foreign Currencies
 
    Assets and liabilities of the Company’s subsidiaries located outside Japan with functional currencies other than Japanese yen are translated into Japanese yen at the rates of exchange in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the year. Gains and losses resulting from translation of financial statements are excluded from earnings and are reported in other comprehensive income (loss).
 
    Gains and losses resulting from foreign currency transactions, including foreign exchange contracts, and translation of assets and liabilities denominated in foreign currencies are included in other income (deductions). Foreign currency exchange losses, net were Yen 3,710 million, Yen 17,800 million and Yen 20,311 million for the years ended December 31, 2005, 2004 and 2003, respectively.
 
(g)   Marketable Securities and Investments
 
    Canon classifies investments in debt and marketable equity securities as available-for-sale, or held-to-maturity securities. Canon does not hold any trading securities which are bought and held primarily for the purpose of sale in the near term. Available-for-sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are reported as a separate component of other comprehensive income (loss) until realized. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts.
 
    Available-for-sale and held-to-maturity securities are regularly reviewed for other-than-temporary declines in carrying value based on criteria that include the length of time and the extent to which the market value has been less than cost, the financial condition and near-term prospects of the issuer and Canon’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value. When such a decline exists, Canon recognizes an impairment loss to the extent by which the cost basis of the investment exceeds the fair value of the investment. Fair value is determined based on quoted market prices, projected discounted cash flows or other valuation techniques as appropriate.
 
    Realized gains and losses are determined on the average cost method and reflected in earnings.
 
    Other securities are stated at cost and reviewed periodically for impairment.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(h)   Allowance for Doubtful Receivables
 
    Allowance for doubtful trade and finance receivables is maintained for all customers based on a combination of factors, including aging analysis, macroeconomic conditions, significant one-time events, and historical experience. An additional reserve for individual accounts is recorded when Canon becomes aware of a customer’s inability to meet its financial obligations, such as in the case of bankruptcy filings. If circumstances related to customers change, estimates of the recoverability of receivables would be further adjusted. When all collection options are exhausted including legal recourse, the accounts or portions thereof are deemed to be uncollectible and charged against the allowance.
 
(i)   Inventories
 
    Inventories are stated at the lower of cost or market value. Cost is determined principally by the average method for domestic inventories and the first-in, first-out method for overseas inventories.
 
(j)   Investments in Affiliated Companies
 
    Investments in affiliated companies over which Canon has the ability to exercise significant influence, but does not hold a controlling financial interest, are accounted for by the equity method.
 
(k)   Impairment of Long-Lived Assets
 
    Long-lived assets, such as property, plant and equipment, and acquired intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of the asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of by sale are reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(l)   Property, Plant and Equipment
 
    Property, plant and equipment are stated at cost. Depreciation is calculated principally by the declining-balance method, except for certain assets which are depreciated by the straight-line method over the estimated useful lives of the assets. The depreciation period ranges from 3 years to 60 years for buildings and 2 years to 20 years for machinery and equipment.
 
    Assets leased to others under operating leases are stated at cost and depreciated to the estimated residual value of the assets by the straight-line method over the period ranging from 2 years to 5 years.
 
(m)   Goodwill and Other Intangible Assets
 
    Goodwill and intangible assets with indefinite useful lives are not amortized, but are instead tested for impairment annually in the fourth quarter of each year, or more frequently if indicators of potential impairment exist. Intangible assets with finite useful lives, consisting primarily of software and license fees, are amortized using the straight-line method over the estimated useful lives, which range from 3 years to 5 years for software and 5 years to 10 years for license fees. Certain costs incurred in connection with developing or obtaining internal use software are capitalized. These costs consist of payments made to third parties and the salaries of employees working on such software development. Costs incurred in connection with developing internal use software are capitalized at the application development stage. In addition, Canon develops or obtains certain software to be sold where related costs are capitalized after establishment of technological feasibility.
 
(n)   Environmental Liabilities
 
    Liabilities for environmental remediation and other environmental costs are accrued when environmental assessments or remedial efforts are probable and the costs can be reasonably estimated. Such liabilities are adjusted as further information develops or circumstances change. Costs of future obligations are not discounted to their present values.
 
(o)   Income Taxes
 
    Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(o)   Income Taxes (continued)
 
    Canon records a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not realizable.
 
(p)   Issuance of Stock by Subsidiaries and Equity Investees
 
    The change in the Company’s proportionate share of a subsidiary’s or equity investee’s equity resulting from the issuance of stock by the subsidiary or equity investee is accounted for as an equity transaction.
 
(q)   Net Income per Share
 
    Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during each year. Diluted net income per share includes the effect from potential issuance of common stock based on the assumption that all convertible debentures were converted into common stock.
 
(r)   Revenue Recognition
 
    Canon generates revenue principally through the sale of consumer products, equipment, supplies, and related services under separate contractual arrangements. Canon recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred and title and risk of loss have been transferred to the customer, the sales price is fixed or determinable, and collectibility is probable.
 
    For arrangements with multiple elements, which may include any combination of equipment, installation and maintenance, Canon allocates revenue to each element based on its relative fair value if such element meets the criteria for treatment as a separate unit of accounting as prescribed in the Emerging Issues Task Force Issue No. 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” Otherwise, revenue is deferred until the undelivered elements are fulfilled as a single unit of accounting.
 
    Revenue from sales of consumer products including office imaging products, computer peripherals, business information products and cameras is recognized upon shipment or delivery, depending upon when title and risk of loss transfer to the customer.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(r)   Revenue Recognition (continued)
 
    Revenue from sales of optical equipment such as steppers and aligners sold with customer acceptance provisions related to their functionality is recognized when the equipment is installed at the customer site and the specific criteria of the equipment functionality are successfully tested and demonstrated by Canon. Service revenue is derived primarily from maintenance contracts on equipment sold to customers and is recognized over the term of the contract.
 
    Most office imaging products are sold with service maintenance contracts for which the customer typically pays a base service fee plus a variable amount based on usage. Revenue from these service maintenance contracts is recognized as services are provided.
 
    Revenue from the sale of equipment under sales-type leases is recognized at the inception of the lease. Income on sales-type leases and direct-financing leases is recognized over the life of each respective lease using the interest method. Leases not qualifying as sales-type leases or direct-financing leases are accounted for as operating leases and related revenue is recognized over the lease term.
 
    Canon records estimated reductions to sales at the time of sale for sales incentive programs including product discounts, customer promotions and volume-based rebates. Estimated reductions in sales are based upon historical trends and other known factors at the time of sale. In addition, Canon provides price protection to certain resellers of its products, and records reductions to sales for the estimated impact of price protection obligations when announced.
 
    Estimated product warranty costs are recorded at the time revenue is recognized and are included in selling, general and administrative expenses. Estimates for accrued product warranty costs are based on historical experience, and are affected by ongoing product failure rates, specific product class failures outside of the baseline experience, material usage and service delivery costs incurred in correcting a product failure.
 
(s)   Research and Development Costs
 
    Research and development costs are expensed as incurred.
 
(t)   Advertising Costs
 
    Advertising costs are expensed as incurred. Advertising expenses were Yen 106,250 million, Yen 111,770 million and Yen 100,278 million for the years ended December 31, 2005, 2004 and 2003, respectively.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(u)   Shipping and Handling Costs
 
    Shipping and handling costs totaled Yen 50,052 million, Yen 46,953 million and Yen 40,660 million for the years ended December 31, 2005, 2004 and 2003, respectively, and are included in selling, general and administrative expenses in the consolidated statements of income.
 
(v)   Derivative Financial Instruments
 
    All derivatives are recognized at fair value and are included in prepaid expenses and other current assets, or other current liabilities on the consolidated balance sheets. On the date the derivative contract is entered into, Canon designates the derivative as either a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value” hedge), or a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge). Canon formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. Canon also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, Canon discontinues hedge accounting prospectively.
 
    Changes in the fair value of a derivative that is designated and qualifies as a fair-value hedge, along with the loss or gain on the hedged asset or liability or unrecognized firm commitment of the hedged item that is attributable to the hedged risk, are recorded in earnings. Changes in the fair value of a derivative that is designated and qualifies as a cash-flow hedge are recorded in other comprehensive income (loss), until earnings are affected by the variability in cash flows of the hedged item. Gains and losses from hedging ineffectiveness are included in other income (deductions). Gains and losses excluded from the assessment of hedge effectiveness (time value component) are included in other income (deductions).
 
    Canon also uses certain derivative financial instruments which are not designated as hedges. Canon records these derivative financial instruments on the consolidated balance sheets at fair value. The changes in fair values are immediately recorded in earnings.
 
(w)   Guarantees
 
    Canon recognizes, at the inception of a guarantee, a liability for the fair value of the obligation it has undertaken in issuing guarantees.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(x)   New Accounting Standards
 
    In November 2004, the FASB issued SFAS No. 151, “Inventory Costs—an amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal years beginning after June 15, 2005 and is required to be adopted by Canon in the first quarter beginning January 1, 2006. Canon is currently evaluating the effect that the adoption of SFAS 151 will have on its consolidated results of operations and financial condition but does not expect SFAS 151 to have a material impact.
 
    In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets—an amendment of APB Opinion No. 29” (“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for the fiscal periods beginning after June 15, 2005 and was adopted by Canon in the third quarter ended September 30, 2005. The adoption of SFAS 153 did not have a material impact on the consolidated results of operations and financial condition of Canon.
 
    In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3 “Reporting Accounting Changes in Interim Financial Statements,” and provides guidance on the accounting for and reporting of accounting changes and error corrections. SFAS 154 establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted by Canon in the first quarter beginning January 1, 2006. Canon is currently evaluating the effect that the adoption of SFAS 154 will have on its consolidated results of operations and financial condition but does not expect SFAS 154 to have a material impact.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(x)   New Accounting Standards (continued)
 
    In June 2005, the FASB issued FSP FAS 143-1, “Accounting for Electronic Equipment Waste Obligations” (“FSP 143-1”). FSP 143-1 provides guidance on the accounting for certain obligations associated with the Waste Electrical and Electronic Equipment Directive (the “Directive”), adopted by the European Union (“EU”). Under the Directive, the waste management obligation for historical equipment (products put on the market on or prior to August 13, 2005) remains with the commercial user until the customer replaces the equipment. FSP 143-1 is required to be applied to the later of the first reporting period ending after June 8, 2005 or the date of the Directive’s adoption into law by the applicable EU member countries. Canon adopted FSP 143-1 in the third quarter ended September 30, 2005 and has determined that its effect did not have a material impact on its consolidated results of operations and financial condition in 2005.
 
    In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP 115-1”). FSP 115-1 provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 is required to be applied to reporting periods beginning after December 15, 2005 and is required to be adopted by Canon in the first quarter beginning January 1, 2006. Canon is currently evaluating the effect that the adoption of FSP 115-1 will have on its consolidated results of operations and financial condition but does not expect FSP 115-1 to have a material impact.

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1.   Basis of Presentation and Significant Accounting Policies (continued)
 
(y)   Reclassification
 
    Certain reclassifications have been made to the prior years’ consolidated financial statements to conform with the presentation used for the year ended December 31, 2005.
 
2.   Foreign Operations
Amounts included in the consolidated financial statements relating to subsidiaries operating in foreign countries are summarized as follows:
                         
    2005     2004     2003  
    (Millions of yen)  
Total assets
  ¥ 1,751,011     ¥ 1,500,197     ¥ 1,339,854  
Net assets
    767,711       632,657       564,041  
Net sales
    2,774,443       2,548,700       2,341,221  
Net income
    81,916       70,227       74,274  

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Canon Inc. and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3.   Marketable Securities and Investments
The cost, gross unrealized holding gains, gross unrealized holding losses and fair value for available-for-sale securities and held-to-maturity securities by major security type at December 31, 2005 and 2004 were as follows:
                                 
    December 31, 2005  
            Gross     Gross        
            unrealized     unrealized        
            holding     holding     Fair  
    Cost     gains     losses     value  
    (Millions of yen)  
Current:
                               
Available-for-sale: