UNITED STATES SURGICAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note A - Summary of Significant Accounting Policies

United States Surgical Corporation and Subsidiaries (the Company) is primarily engaged in developing, manufacturing and marketing a proprietary line of technologically advanced surgical wound management products to hospitals throughout the world. The Company currently operates domestically and internationally through subsidiaries, divisions, and distributors.

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Consolidation. The consolidated financial statements include the accounts and transactions of United States Surgical Corporation and Subsidiaries, excluding intercompany accounts and transactions. Certain subsidiaries(including branches), operating outside the United States, are included in the consolidated financial statements on a fiscal-year basis ending November 30.

Cash and Cash Equivalents. Cash and cash equivalents includes cash on hand, interest bearing demand deposits, and interest bearing short-term investments with original maturities of one month or less.

Inventories. Inventories are stated at the lower of cost (first-in, first-out method) or market.

Property, Plant, and Equipment. Depreciation and amortization is provided using the straight-line method over the following estimated useful lives:

The Company capitalizes interest incurred on funds used to construct Property, plant, and equipment. Interest capitalized during 1996, 1995 and 1994 was immaterial.

Other Assets. The Company capitalizes and includes in Other assets the costs of acquiring patents on its products, licenses to use purchased patents for current and future products, the costs of computer software developed and used in its information processing systems and goodwill arising from the excess of cost over the fair value of net assets of purchased businesses. The Company evaluates the carrying value of its long lived assets and identifiable intangibles, including goodwill, for possible impairments which, if applicable, are recognized when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Costs of Other assets are amortized on the straight-line basis over the following estimated useful lives:

In addition, Other assets contains investments held in certain marketable securities which are recorded at fair value.

Revenue Recognition. Revenues from sales, net of estimated returns, are recognized when products are sold directly by the Company to ultimate consumers, primarily hospitals, or to authorized distributors.

Foreign Currency Translation. For translation of the financial statements of its international operations the Company has determined that the local currencies of its international subsidiaries are the functional currencies. Assets and liabilities of foreign operations are translated at year end exchange rates, and income statement accounts are translated at average exchange rates for the year. The resulting translation adjustments are made directly to the Accumulated Translation Adjustments component of Stockholder's Equity. Foreign currency transactions are recorded at the exchange rate prevailing at the transaction date.

Net Income per Common Share. Net income per common share is based on the weighted average number of common shares and, where material, common share equivalents (stock options, contingent stock, contingent stock right issuances, and convertible preferred stock) outstanding. Common share equivalents are not included in the computation of net income per share in 1996, 1995 and 1994 since the effect of their inclusion would be antidilutive.

Adoption of FAS 123. In 1996, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123). FAS 123 encourages, but does not require companies to record at fair value compensation cost for stock-based employee compensation plans. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock.

Certain comparative amounts in the Consolidated Balance Sheet and related Notes to Consolidated Financial Statements as of December 31, 1995 have been adjusted to conform to the 1996 presentation.

Note B - Common Stock Offering

In the second quarter of 1996 the Company sold an additional 4.3 million shares of its Common stock in a public offering for approximately $141.8 million net of issuance costs. A portion of the proceeds was used to repay certain domestic bank debt and the balance of the proceeds which is reflected in the $106.7 million of cash and cash equivalents at December 31, 1996 will be used for general corporate purposes, including partially financing the Company's current tender offer (see Note C). The impact of this issuance of common stock had an immaterial effect on net income per common share in 1996.

Note C - Tender Offer

On August 2, 1996 the Company commenced an offer to purchase all of the outstanding shares of common stock of Circon Corporation at a price of $18 per share, net to the seller in cash. As a result of Circon's inability to deliver improved financial performance, the tender offer was reduced to $17 per share effective December 16, 1996. Circon Corporation has placed several impediments between its shareholders and the present tender offer. The Company is presently seeking legal remedy to remove these impediments to complete this transaction. Currently, the tender offer has been extended through February 13, 1997. As of December 13, 1996 (the termination date of the previous tender period), 7,726,896 common shares had been tendered. These shares, plus the 1,000,100 shares previously purchased by the Company, represented approximately 66% of Circon Corporation's outstanding common stock as reported by Circon in its public reports for the period ended September 30, 1996. The Circon Corporation common stock, along with other securities, are included in Other assets. These available-for-sale securities have a fair value of approximately $21 million and a cost of approximately $17 million at December 31, 1996.

Note D - Restructuring Charges

The Company recorded restructuring charges of approximately $7 million in 1995. These restructuring charges related primarily to lease termination and employee severance costs associated with the relocation of one of the Company's largest international subsidiaries as part of the plan to centralize the distribution of the Company's products to its European customers. In addition, severance payments and other charges were incurred in 1995 in relation to the restructuring of the Company's manufacturing plants. The majority of the cash outlays relative to severance-related restructuring charges were made in the third and fourth quarters of 1995 with the remainder of the cash outlays occurring during 1996. The 1995 restructuring charges were substantially offset by the reversal of restructuring cost estimates in excess of ultimate costs which were originally recognized in the Company's 1993 consolidated statements of operations.

Accrued liabilities at December 31, 1996 and 1995 included approximately $4 million and $9 million, respectively, which related primarily to severance costs and accrued lease obligations associated with the Company's 1995 and 1993 restructuring charges. Such remaining restructuring charges at December 31, 1996 will have no effect on liquidity. The Company has either terminated or bought out the leases of the leased properties and paid substantially all employee severence costs which were part of the 1993 restructuring charges. The majority of the 1995 accrued termination charges and other restructuring charges were liquidated during 1996.

Note E - Acquisitions

The Company acquired Surgical Dynamics, Inc., (a subsidiary of E-Z-EM, Inc.) a developer, manufacturer, and distributor of surgical devices for use in spinal procedures, in November 1995 for $60 million in a cash transaction. The acquisition was accounted for by the purchase method of accounting. Goodwill of approximately $58 million resulting from the acquisition will be amortized on a straight-line basis to operations over 20 years. The Company has made an allocation of the purchase price based on the estimated fair values of assets and liabilities acquired. Results of operations subsequent to acquisition are included in the Company's consolidated financial statements.

The Company completed on September 29, 1995 its 6.1 billion Yen (approximately $62 million or a present value of $54 million) purchase acquisition of certain assets from the Company's former distributor in Japan. The Company has made an allocation of the purchase price based on the estimated fair values of net assets acquired. The Company and the former distributor had agreed that all of the conditions to closing the purchase had either been met or could be met as of April 1, 1995 and, accordingly, had entered into an agency agreement effective April 1, 1995 under which the Company assumed the risks and rewards of selling the Company's products to third parties in Japan and recognized, since April 1, 1995, the former distributor's revenue and selling expenses in the Company's consolidated financial statements relative to the sale of the Company's products in Japan. Approximately 2.5 billion Yen ($22 million) was recorded as goodwill.

In the third quarter of 1995, the Company acquired through purchase transactions certain assets of an internal stapling business and a 9.5% equity interest in a biopharmaceutical company (Alexion Pharmaceutical Company). In addition, the Company acquired the exclusive worldwide rights to market transgenic pig organs from Alexion. In the third quarter of 1996, the Company acquired 80% of a foreign corporation (Medolas Gesellschaft fur Medizintechnik GmbH) through a purchase transaction along with an option to purchase the remaining 20% in the future. This foreign corporation will exclusively supply the Company with products in the medical field. These acquisitions did not currently have a material impact on the Company's consolidated results of operations or financial position.

The unaudited 1995 consolidated results of operations on a pro-forma basis as though the 1995 purchase business combinations of Surgical Dynamics, Inc., and certain assets from the Company's former Japanese distributor, and excluding the purchase of Alexion, had collectively been completed by the Company as of the beginning of 1995 is as follows (dollars in thousands, except per share amount):

The pro-forma financial information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisitions been consummated as of the above dates, nor are they necessarily indicative of future operating results.

Note F - Property, Plant, and Equipment

At December 31, 1996 and 1995, Property, plant and equipment (at cost) comprised the following items:

Property, plant, and equipment includes land and buildings in Elancourt, France with a net book value at December 31, 1996 and 1995 of $79 million and $82 million, respectively. During 1996 the Company took out of service and removed from its balance sheet Property, plant, and equipment which had an original cost of $27 million and was fully depreciated.

Note G - Other Assets

At December 31, 1996 and 1995 Other assets (net of accumulated amortization of $57 million and $73 million in 1996 and 1995, respectively) was comprised of the following items:

During 1996 the Company removed from its Balance Sheet fully amortized Other assets with a cost of $11 million.

Investments at fair value consist of available-for-sale securities which have an original cost of $17 million and $4 million at December 31, 1996 and 1995, respectively.

Note H - Income Taxes

A summary of the source of income (loss) before income taxes follows:

A summary of the provision for income taxes follows:

A reconciliation between income taxes based on the application of the statutory federal income tax rate (35%) to income before income taxes and the provision for income taxes as set forth in the Consolidated Statements of Operations follows:

The Company has provided for taxes on the income of its subsidiary's operations in Puerto Rico at an effective rate that is lower than the U.S. federal income tax statutory rate. This rate reflects the fact that approximately 90% of income is exempt from local taxes in Puerto Rico as well as the availability of a tax credit under Section 936 of the Internal Revenue Code. Withholding taxes at a negotiated rate of 9% (8% in 1995) have been provided on the expected repatriation of the income of this subsidiary.

At December 31, 1996 and 1995 deferred tax liabilities and assets under FAS 109 were comprised of the following:

Deferred taxes resulted from temporary differences in the recognition of revenue and expense for tax and financial statement purposes. The sources of the deferred taxes include: the use of accelerated methods of computing depreciation for income tax purposes and the straight-line method for financial reporting purposes; expensing certain patent costs as incurred for income tax purposes and capitalizing and amortizing them over their estimated useful lives for financial reporting purposes; and other temporary differences applicable to current and deferred assets and liabilities.

At December 31, 1996 and 1995 net current deferred tax assets of $45 million and $23 million, respectively, and net non-current deferred tax assets of $60 million and $32 million, respectively, were included in the Consolidated Balance Sheet captions Other current assets and Other assets, respectively. Current deferred tax liabilities of $1 million in 1996 and 1995 and non-current deferred tax liabilities of $23 million in 1996 and $8 million in 1995 were included in the Consolidated Balance Sheet captions Income taxes payble and Deferred income taxes, respectively.

The Company's loss carryforwards prior to 1993 are primarily attributable to compensation expense deductions on its income tax returns which were not recognized for financial accounting purposes. The continuing increases in levels of current and projected future domestic taxable income enabled the Company to reduce the valuation allowance in 1996. A valuation allowance in the amount of $58 million has been recorded as of December 31, 1996 because of the uncertainty over the future utilization of the tax benefit of certain of its gross deferred domestic and foreign tax assets. As of January 1, 1996 and 1995, the valuation allowance was $129 million and $205 million, respectively.

At December 31, 1996 the Company's consolidated subsidiaries have unremitted earnings of $120 million on which the Company has not accrued a provision for federal income taxes since these earnings are considered to be permanently invested. The amount of the unrecognized deferred tax liability relating to unremitted earnings was approximately $36 million at December 31, 1996.

The Company has available for U.S. Federal income tax return purposes the following net operating loss and tax credit carryforwards:

In addition, the Company has available for state and foreign income tax return purposes net operating loss carryforwards of $92 million and $91 million, respectively, and tax credits of $3.5 million, which expire at various dates.

The exercise of stock options which have been granted under the Company's various stock option plans and the vesting of restricted stock give rise to compensation which is includable in the taxable income of the applicable employees and deductible by the Company for federal and state income tax purposes. Such compensation results from increases in the fair market value of the Company's Common Stock subsequent to the date of grant of the applicable exercised stock options and restricted stock and, accordingly, in accordance with Accounting Principles Board Opinion No. 25, such compensation is not recognized as an expense for financial accounting purposes and the related tax benefits are taken directly to Additional Paid-in Capital. In the years ended December 31, 1990 - 1992 such deductions resulted in significant federal and state deductions which may be carried forward. Utilization of such deductions will increase Additional Paid-in Capital. The tax benefit recognized from compensation deductions arising from the exercise of stock options was approximately $49 million in 1996, $8 million in 1995, and was immaterial in 1994. Of the $49 million in tax benefit recognized in 1996, approximately $8 million relates to stock options exercised in 1996 and approximately $41 million relates to stock options exercised prior to 1996.

With respect to the U.S. federal net operating loss and credit carryforwards set forth above, the Company estimates that if such carryforwards are ultimately recognizable, the remainder of such tax assets would result in increases to Additional Paid-in Capital of up to approximately $18 million.

In August 1995, the Company reached agreement with respect to settlement of all issues raised by the Internal Revenue Service (IRS) in its examination of the Company's income tax returns for the years 1984 through 1990. Prior to this resolution, a significant portion of deferred tax assets relating to available net operating loss and tax credit carryforwards had been fully reserved by the Company because of uncertainty over the future utilization of the tax benefits. Based upon circumstances relative to the IRS audit and the Company's estimate of future domestic taxable income, it is more likely than not that a significant portion of such fully reserved assets will be realized in the future. As a result, in the third quarter of 1995 the Company reduced the valuation allowances related to a significant portion of these deferred tax assets by $54.3 million (change in valuation allowances in 1995 was a reduction of $75.6 million), increased its current tax liabilities by $28.6 million for the remaining estimated tax liabilities relating to years subsequent to 1990, decreased tax assets by $7.4 million, recognized a net credit to the tax provision of $10.0 million ($.18 per common share) and recorded a credit to Additional Paid-in Capital (for windfall tax benefits related to net operating losses generated from stock compensation deductions in prior years) of $8.3 million.

Note I - Accrued Liabilities

Included in Accrued liabilities at December 31, 1996 are accrued rent for the Company's North Haven facilities $34 million (1995 - $14 million), accrued shareholders' settlement and associated fees $20 million (1995 - $13 million), accrued payroll, property and sales taxes $19 million (1995 - $17 million), accrued commissions $16 million (1995 - $16 million) and accrued restructuring charges $4 million (1995 - $9 million).

Note J - Long-Term Debt

At December 31, 1996, the scheduled principal repayments under loan agreements and future minimum payments under a financing lease and note payable were as follows:

At December 31, 1996 the Company's long-term debt consisted of $22 million in Yen denominated bank borrowings, $88 million in French Franc denominated financing lease obligations outstanding relating to its European headquarters office building and distribution center complex in Elancourt, France, and $32 million in Yen denominated notes payable outstanding to its former Japanese distributor which arose as part of the Company's acquisition of certain assets from the former Japanese distributor. In the second quarter of 1996 the Company sold 4.3 million shares of its common stock in a public offering for approximately $141.8 million of proceeds net of issuance costs. A portion of the proceeds were used to repay certain domestic bank debt, and the balance of the proceeds which is reflected in the $106.7 million of cash and cash equivalents at December 31, 1996 will be used for general corporate purposes, including partially financing the Company's existing tender offer for Circon Corporation.

During December 1995, the Company entered into a new five year, $325 million syndicated credit agreement which replaced its previous $350 million revolving credit facility which was scheduled to mature in January 1997. The new syndicated credit facility provides the Company with a choice of interest rates based upon the banks' CD rate, prime rate or the London Interbank Offered Rate (LIBOR) for US dollar borrowings and Tokyo Interbank Offered Rate (TIBOR) for yen borrowings. The actual interest charges paid by the Company are determined by a pricing schedule which considers the ratio of consolidated debt at each calendar quarter end to consolidated earnings before interest, taxes, depreciation and amortization for the trailing twelve months. The effective interest rate on long-term bank debt outstanding as of December 31, 1996 and 1995 was 5.3% and 7.4%, respectively. The interest expense in 1996, 1995 and 1994 was $14 million, $23 million and $21 million, respectively. Such interest expense has been reduced, as reflected on the Consolidated Statement of Operations by interest income of $5 million, $2 million and $3 million in 1996, 1995 and 1994, respectively.

The Company has entered into an additional conditional committed bank term loan facility of $175 million during the third quarter of 1996 to exclusively finance its tender offer. This conditional term loan facility has similar terms and conditions to the Company's present syndicated bank credit facility.

The new credit agreement, conditional term loan facility, and the Company's operating lease for its primary domestic manufacturing, distribution and warehousing complex in North Haven, Connecticut, provide for certain restrictions including sales of assets, capital expenditures, dividends and subsidiary debt. The most restrictive covenants of the Company's financing agreements require the maintenance of certain minimum levels of tangible net worth, fixed charges coverage and a maximum ratio of total debt to total capitalization, as defined. The Company is prohibited from declaring dividends on its common stock in excess of 20% of net income, subject to changes in the number of common shares outstanding, until it achieves investment grade status, as defined. Additionally, during 1996 and 1995, the Company entered into uncommitted facilities for 5 billion Japanese Yen (approximately $44 million) with two Japanese banks and $125 million with five other banks. The uncommitted credit agreements are short term in nature. Borrowings under these agreements were approximately $15 million at December 31, 1996. Such borrowings have been categorized as long-term debt as such borrowings will be refinanced under the Company's five-year bank credit agreement. The Company is in full compliance with all of the covenants associated with its various financing agreements.

The Company's French franc denominated financing lease requires principal amortization in varying amounts over the remaining twelve year term of the lease with a balloon payment of approximately 42 million French franc ($8 million) at the end of the lease. Interest is payable at a rate approximately 1.4% above Paris Interbank Offered Rate (PIBOR). After considering the effects of an interest rate swap agreement, the effective interest rate on the financing lease debt was approximately 6.8% and 8.05% at December 31, 1996 and 1995, respectively.

The Company's yen-denominated note payable is non-interest bearing and repayable annually in amounts based upon the higher of 350 million yen or 8% of the landed value of products shipped to the Company's subsidiary in Japan. In any event, any notes payable still outstanding on December 31, 2001 must be repaid on that date. The Company has calculated the present value of these notes using a discount rate of 4% and the estimated value of products expected to be shipped to its subsidiary over the next five years. Based upon these assumptions, the Company estimates that the present value of the final payment on December 31, 2001 will be approximately $16 million.

Note K - Stockholders' Equity

On March 28, 1994 the Company issued approximately $200 million of 9.76% Series A Convertible Preferred Stock (convertible into a maximum of approximately 8.9 million shares or a minimum of approximately 8.5 million shares of the Company's Common Stock), par value $5 per share, in an offering exempt from the registration requirements of the Securities Act of 1933, as amended. Dividends on the Convertible Preferred Stock are cumulative at the annual rate of $110 per share, payable quarterly in arrears commencing July 1, 1994. The shares trade in units of depositary shares, with each depositary share representing one-fiftieth interest in one share of preferred stock. On April 1, 1998 each share of Convertible Preferred Stock outstanding will automatically convert into 50 shares of Common Stock of the Company, and prior to this date it may be converted into 47.65 shares of Common Stock at any time at the option of the holder. The Company may redeem the Convertible Preferred Stock at any time after April 1, 1997 for a number of shares of Common Stock with a market value equal to $1,025 (equivalent to $20.50 per depositary share) together with an additional cash dividend of up to $27.50 per share with the additional cash dividend declining ratably after April 1, 1997 to $0 by March 1, 1998. However, holders of the Convertible Preferred Stock are expected to convert the preferred stock rather than accept redemption, the holders of the preferred stock forgoing any additional preferred stock dividend payment by the Company but receiving a greater number of common shares than would be the case on a redemption. Following conversion on redemption, no further preferred dividends are payable. The Preferred Stock trades principally as depositary receipts, each representing a one-fiftieth interest in a share of Preferred Stock. The proceeds from the sale of Preferred Stock were used to reduce bank indebtedness.

The Company had 63,286,797 and 57,165,938 shares of its $.10 par value Common Stock outstanding as of December 31, 1996 and 1995, respectively. In the past, the Company announced programs to repurchase up to a total of 9,200,000 shares of its outstanding Common Stock. As of December 31, 1996, a total of 8,712,537 shares had been acquired at a total cost of $89.3 million. No treasury shares had been acquired in 1995 and 1996. Acquired shares are being held as treasury shares, the majority of which are reserved for issuance upon conversion of the Company's Preferred Stock.

Shares of Common Stock reserved for future issuance in connection with restricted stock awards, stock option plans and employee stock purchase plans amounted to 18,015,704 and 17,303,361 at December 31, 1996 and 1995, respectively. The Compensation/Option Committee (the "Committee") of the Board of Directors is responsible for administering the Company's stock plans. The Company's stock option plans vest for periods up to five years from the date of grant.

The Restricted Stock Incentive Plan (the "Incentive Plan") provides for grants to key employees of the Company's Common Stock in the maximum aggregate amount of 5,000,000 shares. As of December 31, 1996, 3,839,740 shares were issued and vested under the Incentive Plan and 142,160 shares were cancelled. There were no restricted stock grants during the three-year period ended December 31, 1996. The Plan was terminated during the first quarter of 1996.

The 1990 Employee Stock Option Plan (the "1990 Option Plan") provides for grants to key employees and certain key consultants of options and stock appreciation rights for up to 11,000,000 shares of the Company's Common Stock at the per share market price at the date of grant unless the Committee determines otherwise. As of December 31, 1996, no stock appreciation rights have been granted. Subject to a maximum exercise period of fifteen years, the exercise period of awards under the 1990 Option Plan will be as determined by the Committee.

The 1993 Employee Stock Option Plan (the "1993 Option Plan") provides for grants to key employees (excluding executive officers) of options and stock appreciation rights for up to 4,500,000 shares of the Company's Common Stock at the per share market price at the date of grant unless the Committee deems otherwise. As of December 31, 1996 no stock appreciation rights have been granted. Subject to a maximum exercise period of fifteen years, the exercise period of awards under the 1993 Option Plan will be as determined by the Committee.

The 1996 Employee Stock Option Plan (the "1996 Option Plan") provides for grants to Officers of the Company of options and stock appreciation rights for up to 2,500,000 shares of the Company's Common Stock at no less than the per share market price at the date of grant. As of December 31, 1996 no stock appreciation rights have been granted. Subject to a maximum exercise period of fifteen years, the exercise period of awards under the 1996 Option Plan will be as determined by the Committee.

The Service-Based Stock Option Plan (the "Service Option Plan") provides for grants of options for up to 1,144,132 shares of the Company's Common Stock at the per share market price at the date of grant to individuals employed by the Company who are within an eligible category. Options under the Service Option Plan are awarded for a fixed number of shares of Common Stock based solely upon the eligible recipient's years of service within the eligible category, and are exercisable for a period of up to ten years.

The Outside Directors Stock Plan provides for an aggregate maximum of up to 160,000 shares of Common Stock to be issued under restricted stock awards and option grants to certain non-employee members of the Board of Directors which are exercisable for a period up to ten years. At December 31, 1996 and 1995, restricted stock awards and option grants for 154,000 shares and 134,000 shares, respectively, had been granted under the Outside Directors Stock Plan. As of December 31, 1996 and 1995, 6,000 and 26,000 shares, respectively, are reserved for future issuance under the Outside Directors Stock Plan.

A summary of stock option transactions under the employee option plans and the Outside Directors Stock Plan for each of the three years in the period ended December 31, 1996 follows:

The following tables summarize information about stock options outstanding at December 31, 1996:

Under the USSC Employees 1979 Stock Purchase Plan (the "1979 Purchase Plan") and the 1994 Employees Stock Purchase Plan (the "1994 Purchase Plan"), all eligible employees may authorize payroll deductions of up to 10% of their base earnings, as defined, to purchase shares of the Company's Common Stock at 85% of the market price when such deductions are made. There are no charges or credits to income in connection with the Purchase Plan. The plans will continue in effect as long as shares authorized under the Purchase Plan remain available for issuance thereunder. The Company has reserved 2,400,000 shares of its Common Stock for issuance under the 1979 Purchase Plan, of which 135,648 shares are available for future issuance, and it has reserved 650,000 shares of its Common Stock for issuance under the 1994 Purchase Plan, of which 278,146 are available for future issuance, at December 31, 1996.

The estimated fair value of options granted during 1996 and 1995 were $8.91 per share and $7.82 per share, respectively. The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for its stock option and purchase plans. No compensation cost has been recognized for its fixed stock option plans and its stock purchase plans. Had compensation cost for the Company's stock option plans and its stock purchase plans been determined based on the fair value at the option grant dates for awards in accordance with the accounting provisions of FAS 123, the Company's net income and earnings per share for the years ended December 31, 1996 and 1995 would have been reduced to the pro forma amounts indicated below:

The fair value of options granted under the Company's fixed stock option plans during 1996 and 1995 was estimated on the dates of grant using the Black-Scholes options-pricing model with the following weighted-average assumptions used: dividend yield of approximately .3%, expected volatility of approximately 32%, risk free interest rate of approximately 6%, and expected lives of option grants of approximately four years. Pro forma compensation cost related to shares purchased under the Employee Stock Purchase Plan is measured based on the discount from market value. The effects of applying FAS 123 in this pro forma disclosure are not indicative of future pro forma effects. FAS 123 does not apply to awards prior to 1995, and additional awards in future years are anticipated.

Note L - Segment and Geographic Area Information

The Company develops, manufactures and markets wound management products which constitute a single business segment. The following information sets forth geographic information with respect to the Company's net sales, operating profits and identifiable assets. Intercompany transactions are made at established transfer prices.

Note M - Commitments and Contingencies

The Company is engaged in litigation as a defendant in cases involving alleged patent infringement, product liability claims and a consolidated shareholders' class action suit. In the opinion of management, based upon advice of counsel, the ultimate outcome of these lawsuits should not have a material adverse effect on the Company's consolidated financial statements.

In November, 1996 the Company entered into an agreement in settlement of the shareholder class action suits filed against the Company and certain individually named defendants. The principal terms of the settlement are as follows: issuance and payment to the members of the class of 315,000 shares of the Company's common stock (fair value $12.2 million), $3.5 million in cash, and issuance of contingent stock rights (fair value $2.9 million) with respect to each of the 315,000 shares of common stock issued in the settlement. If the Company's common stock reaches a price of $70 per share for either forty five consecutive trading days or one hundred trading days in total during the two year period from the date of issuance of the 315,000 shares of common stock to the members of the class, the contingent stock rights will extinguish. The payment and issuance of the common stock and contingent stock rights will take place on final court approval of the settlement and the plan for distribution of the securities and cash to members of the class. The Company has provided for the estimated cost of the settlement in its consolidated financial statements, the substantial portion of which will be funded by the Company's insurance carriers. Certain individually named defendants in the case assigned to the Company during 1995 various insurance claims relating to the reduction of the terms of certain outstanding option grants to which they agreed to in connection with the settlement of a shareholder derivative claim. The Company believes this assignment facilitated the Company's ability to obtain insurer funding of this settlement. The Company also believes that it and the individually named defendants have substantial defenses against the shareholder class action claims; however, because of the continued expenses, distractions and potential risks of litigation, the Company concluded that a settlement on terms largely funded by insurance coverage was in the Company's and shareholders' best interests.

The Company is committed to certain undertakings, including the maintenance of specified levels of employment and capitalization for its Puerto Rican subsidiary.

Under an agreement with Progressive Angioplasty Systems, Inc. (PAS) dated February 4, 1997, the Company purchased 12.5% of PAS for $15 million and has a six month evaluation period in which to exercise its right to acquire the remaining 87.5% PAS. The purchase price, if the option is exercised, is $75 million of the Company's common stock, with an additional $75 million of the Company's common stock payable when or if certain milestones and sales objectives are met.

The future minimum rental commitments for building space, leasehold improvements, data processing and automotive equipment for all operating leases as of December 31, 1996, were as follows: 1997 - $82 million; 1998 - $95 million; 1999 - $73 million; 2000 - $69 million; 2001 - $68 million; after 2001 - $145 million. Rent expense was $40 million, $33 million and $31 million in 1996, 1995 and 1994, respectively. The Company's North Haven lease agreement includes contingent rent provisions based on formulas utilizing the consumer price index. The Company's North Haven facilities are leased from a trust, of which the original developer (the "Owner Participant") holds the beneficial interest. The Owner Participant has the right to require the Company or the Company's designee to purchase the Owner Participant's beneficial interest. This right cannot be exercised by the Owner Participant until January 1998 and continues for a period of four years thereafter. The Company's obligation, if the right is exercised, would be to take title to the beneficial interest in the trust, or find another investor, suitable to the noteholders who financed these facilities, to take such title. In either case the Company's obligations as lessee under the lease would not change. The Company would be obligated, whether or not the right is exercised, to make payments called for under the existing lease of approximately $57 million annually through the year 2002, a payment of $28 million in January 2003 and nominal annual payments of $100,000 through 2022. In addition, the Company is obligated to make additional contingent rental payments based upon the consumer price index. There are presently several alternatives available to the Owner Participant and the Company relative to the additional contingent rental payments. The earliest potential payment of approximately $19 million could be due as early as January 1998 if the Owner Participant exercises the right to sell the facility to the Company. If this right is not exercised, and the Owner Participant does not elect the one-time payment of contingent rent of approximately $19 million, the determination of the additional contingent rental payments will be based upon movements in the consumer price index during the period September 1996 to September 1999 with an annual cap on the consumer price index movement of 2.5% per year. If the second option is chosen, additional contingent rental payments cannot exceed approximately $39 million as stipulated in the agreement. Under the second option, the Company can elect to pay free of interest from 2004 to 2023 the additional contingent rental payments in excess of $19 million. The present value of the contingent rental payments under the second option of approximately $23 million would be a charge to rent expense during the contingent rent period, September 1996 to September 1999, in comparison to the $19 million charge under the other option. Through December 31, 1996, the Company has accrued $4.5 million related to contingent rental payments.

Note N - Financial Instruments and Off Balance Sheet Risk

Derivatives
The Company has only limited involvement with derivative financial instruments and does not use them for trading purposes. They are used to manage well-defined interest rate and foreign exchange rate risks.

The Company enters into contracts to reduce its exposure to and risk from foreign currency exchange rate changes and interest rate fluctuations in the regular course of the Company's global business. As of December 31, 1996, the Company had approximately $29 million of foreign currency exchange contracts outstanding that will mature at various dates through February 1997. Realized and unrealized foreign currency gains and losses with respect to such contracts which were immaterial in 1996 and 1995 are recognized when incurred and amounted to losses of $4 million in 1994.

The Company swapped with certain banks its exposure to floating interest rates on $50 million of its variable rate U.S. dollar debt and 200 million ($38 million) of variable rate French franc debt. The U.S. dollar debt swap agreements expired in August 1996, and the French franc debt swap agreements will expire in December 1997. The Company made interest payments at rates of approximately 7.8% for the U.S. dollar swap and 8.1% for the French franc swap and received payments based on the floating six-month LIBOR and three-month PIBOR, respectively. The net gain or loss from the exchange of interest rate payments, which is immaterial, is included in interest expense. Based upon the fair value of the Company's French franc interest rate swap agreement at December 31, 1996, termination would require a payment by the Company of approximately $1.8 million dollars. The Company does not currently intend to terminate the remaining interest rate swap agreement prior to the expiration date.

Concentration of Credit Risk
The Company invests its excess cash in both deposits with major banks throughout the world and other high quality short-term liquid money market instruments (commercial paper, bank CDs, government and government agency notes and bills, etc.). The Company has a policy of making investments only with institutions that have at least an "A" (or equivalent) credit rating from a national rating agency. The investments generally mature within six months but certain investments in bank CDs mature from two to five years. The Company has not incurred losses related to these investments.

The Company sells products in the surgical wound management field in most countries of the world. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base. Ongoing credit evaluations of customers' financial condition are performed and, generally, no collateral is required. In certain European countries the Company's receivables are not paid until the customers receive governmental reimbursement for their purchases. The Company has not encountered difficulty in ultimately collecting accounts receivable in these countries. The Company maintains reserves for potential credit losses and such losses, in the aggregate, have not exceeded management's estimates.

Disclosures about Fair Value of Financial Instruments
The carrying amount of cash and cash equivalents approximates fair value due to the short-term maturities of these instruments. The fair value of certificates of deposit, long-term debt and foreign interest rate swap agreements were estimated based on quotes obtained from brokers for those or similar instruments. The fair value of interest rate swap contracts were estimated based on quoted market prices at year-end.

The estimated fair value of the Company's financial instruments are as follows:

The Company believes that the other parties to the above related financial instruments have the ability to perform under such agreements.

Note O - Supplemental Cash Flow Information

The Company purchased certain assets from its former Japanese distributor for approximately 6.1 billion Yen ($62 million or a present value of $53.5 million at date of purchase in 1995). In conjunction with this purchase a long-term payable was recorded in 1995 as follows:

Trademarks of United States Surgical Corporation and its subsidiaries throughout this publication are italicized.
Copyright © 1997 United States Surgical Corporation. All Rights Reserved.
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