Independent auditor’s report

To: The Annual General Meeting of Shareholders of Koninklijke Philips N.V.

Report on the audit of the financial statements 2014

Our opinion

We have audited the financial statements 2014 of Koninklijke Philips N.V. (the Company), Eindhoven, the Netherlands. The financial statements include the consolidated and company financial statements.

In our opinion:

  • the consolidated financial statements give a true and fair view of the financial position of Koninklijke Philips N.V. as at December 31, 2014 and of its result and its cash flows for 2014 in accordance with International Financial Reporting Standards as adopted by the European Union (EU-IFRS) and with Part 9 of Book 2 of the Dutch Civil Code.
  • The company financial statements give a true and fair view of the financial position of Koninklijke Philips N.V. as at December 31, 2014 and of its result for 2014 in accordance with Part 9 of Book 2 of the Dutch Civil Code.

The consolidated financial statements comprise:

  • the consolidated balance sheet as at December 31, 2014;
  • the following statements for 2014: consolidated statements of income, comprehensive income, cash flows and changes in equity for the year then ended; and
  • the notes comprising a summary of the significant accounting policies and other explanatory information.

The company financial statements comprise:

  • the company balance sheet as at December 31, 2014;
  • the company statement of income for 2014; and
  • the notes comprising a summary of the significant accounting policies and other explanatory information.

Basis for our opinion

We conducted our audit in accordance with Dutch law, including the Dutch Standards on Auditing. Our responsibilities under those standards are further described in the “Our responsibilities for the audit of the financial statements” section of our report.

We are independent of Koninklijke Philips N.V. in accordance with the “Verordening inzake de onafhankelijkheid van accountants bij assurance-opdrachten” (ViO) and other relevant independence regulations in the Netherlands. Furthermore, we have complied with the “Verordening gedrags- en beroepsregels accountants” (VGBA).

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion.

Materiality

Misstatements can arise from fraud or errors and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements. The materiality affects the nature, timing and extent of our audit procedures and the evaluation of the effect of identified misstatements on our opinion.

Based on our professional judgment we determined the materiality for the financial statements as a whole at EUR 80 million. Materiality is based on sales, as we consider this benchmark to be the most relevant given the nature of the business and size of the Company and approximates 0.4% of sales. We have also taken into account misstatements and/or possible misstatements that in our opinion are material for qualitative reasons for the users of the financial statements.

We agreed with the Supervisory Board that misstatements in excess of EUR 4 million, which are identified during the audit, would be reported to them, as well as smaller misstatements that in our view must be reported on qualitative grounds.

Scope of our group audit

Koninklijke Philips N.V. is the parent company of the Philips Group (the Group). The financial information of the Group is included in the financial statements of Koninklijke Philips N.V

Considering our ultimate responsibility for the opinion, we are responsible for directing, supervising and performing the group audit. In this context, we have determined the nature and extent of the audit procedures to be performed for group entities (components). Decisive factors were the significance and / or the risk profile of the components. On this basis, we selected the components for which an audit of account balance or specified procedures had to be performed. Furthermore, we have determined the audit procedures that we perform at group level, sector level and in the Finance Operations centers.

We scope components to be involved with the audits of account balances into the group audit where account balances are of significant size, have significant risks of material misstatement to the Group associated with them or are considered significant for other reasons. Where this does not give adequate coverage we use our judgment to scope-in additional procedures on account balances or request the component auditors to perform specified procedures. As a result of our scoping of account balances and the performance of audit procedures at different levels in the organization, our actual coverage varies per account balance and the depth of our audit procedures per account balance varies depending on our risk assessment.

Accordingly, our audit coverage per account balance included in the key audit matters stated below, can be summarized as follows:

  • For goodwill, we have applied a centralized audit approach with specified audit procedures on 90% of the goodwill account balance and limited procedures on the remaining of the goodwill account balance.
  • For income taxes, we have identified 10 entities in the group for which we performed an audit of account balances and/or specified procedures at the component level. These 10 entities represent 90% of the income tax accounts deferred tax assets and income tax provisions. The remaining population is covered by limited procedures performed centrally by the group auditor.
  • For revenue recognition, we have identified 31 entities in the group for which we performed an audit of account balances and/or specified procedures at the component level. These 31 entities represent 58% of sales. This scope is extended by specified procedures on sales performed centrally, representing an additional 17% of sales resulting in a coverage of 75% of sales. The remaining population is covered by limited procedures performed.
  • For contingent liabilities and provisions from legal proceedings, we have applied a centralized audit approach with specified audit procedures performed by the component auditors. Our audit procedures cover 96% of the recognized legal claim provision and all significant legal proceedings without a legal claim provision recognized.

Audits of account balances or specified procedures were performed to materiality levels, the majority of which were based on the relevant local statutory audit materiality which is considerably lower than Group materiality. In the other cases, component materiality was determined by the judgment of the group auditor, having regard to the materiality for the financial statements as a whole and the reporting structure within the Group. Component materiality did not exceed EUR 40 million and the majority of our component auditors applied a component materiality that is significantly less than this threshold.

The group auditor sent detailed instructions to all component auditors, covering the significant areas that should be covered (which included the relevant risks of material misstatement detailed above) and set out the information required to be reported to the group auditor. Based on our risk assessment, the group auditor visited component locations in China, Germany, Indonesia, the Netherlands, Panama, Singapore and the USA. Most of our component auditors visited the Netherlands in 2014 to attend our global audit conference, which is held every three years, to discuss the Group audit, risks, audit approach and instructions. Telephone calls were also held with the auditors of components that were both physically and not physically visited. During these visits and meetings, the audit approach, findings and observations reported to the group auditor were discussed in more detail.

We have used other auditors for the audit of components outside The Netherlands. By performing the procedures mentioned above at components, combined with additional procedures at group level, sector level and at Finance Operations centers, we have been able to obtain sufficient and appropriate audit evidence regarding the group’s financial information to provide an opinion on the financial statements.

Our key audit matters

Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the financial statements. We have communicated the key audit matters to the Supervisory Board. The key audit matters are not a comprehensive reflection of all matters discussed.

These matters were addressed in the context of our audit of the financial statements as a whole and in forming our opinion thereon, and we do not provide a separate opinion on these matters.

Finance Transformation

The Company continued to implement its global Accelerate! initiative, which includes a Finance Transformation program. The Finance Transformation has a significant impact on the Company’s business processes, control activities and internal control responsibilities. We focused on the Finance Transformation as part of our audit because there is a significant risk that a material misstatement could occur if the program was not implemented with proper oversight and a focus on maintaining effective internal controls throughout the process.

Our audit procedures included, amongst others, meetings with the Board of Management and the Audit Committee of the Supervisory Board on a regular basis during the year to understand and monitor the effects of changes to the Company’s internal control environment, across the organization. We performed site visits in three major geographic regions to test the effectiveness of controls impacted by the Finance Transformation and instructed our component auditors globally to perform procedures designed to provide reasonable assurance that a material misstatement did not exist in the financial statements as a result of the program. We also tested monitoring activities executed at different levels of the organization designed to ensure continued effectiveness of the internal control framework during the Finance Transformation.

Valuation of goodwill

Under EU-IFRSs, the Company is required to test the amount of goodwill for impairment, both annually and if there is a trigger for testing. The impairment tests were significant to our audit due to the complexity of the assessment process and significant judgments and assumptions involved which are affected by expected future market or economic conditions. At December 31, 2014, the goodwill amounted to EUR 7.2 billion.

Our audit procedures included, amongst others, the involvement of a valuation expert to assist us in evaluating the assumptions and methodologies used by the Company, in particular those relating to the compound sales growth rate and pre-tax discount rate. The cash flow projections, mainly for Healthcare cash-generating units – Respiratory Care & Sleep Management, Imaging Systems, and Patient Care & Monitoring Solutions and Lighting cash-generating units - Professional Lighting Solutions and Consumer Luminaires have been assessed and challenged by us, and includes an assessment of the historical accuracy of management’s estimates and evaluation of business plans. Based on the impairment test, it was noted that with regard to the headroom for cash-generating unit Consumer Luminaires, the estimated recoverable amount approximates the carrying value of the cash-generating unit. We also assessed the adequacy of the disclosures in Section 12.9, Note 11 Goodwill relating to those assumptions to which the outcome of the impairment test is most sensitive, that is, those that have the most significant effect on the determination of the recoverable amount of goodwill.

Accounting for income tax positions

Income tax was significant to our audit because the assessment process is complex and the amounts involved are material to the financial statements as a whole. The Company has extensive international operations and in the normal course of business makes judgments and estimates in relation to tax issues and exposures resulting in the recognition of other tax liabilities. At December 31, 2014, the net deferred tax assets are valued at EUR 2.4 billion and the other tax liability related to tax uncertainties is valued at EUR 499 million.

We have tested the completeness and accuracy of the amounts reported for current and deferred tax including the assessment of disputes with tax authorities. In this area our audit procedures included, amongst others, assessment of correspondence with the relevant tax authorities, testing the effectiveness of the Company’s internal controls around the recording and continuous re-assessment of the other tax liabilities, and the involvement of our local component auditors including tax specialists in those components determined to be the regions with significant tax risk. In respect of deferred tax assets, we tested management’s assumptions used to determine the probability that deferred tax assets recognized in the balance sheet will be recovered through taxable income in the countries where the deferred tax assets originated and during the periods when the deferred tax assets become deductible. During our procedures, we used amongst others budgets, forecasts and tax laws and in addition we assessed the historical accuracy of management’s assumptions. We also assessed the adequacy of the Company’s disclosure included in Section 12.9, Note 8 Income taxes in respect of income tax positions and uncertain tax positions.

Revenue recognition

Sales contracts for certain projects in the Healthcare and Lighting sectors typically involve multi-element contracts, for example a single sales transaction that combines the delivery of goods and rendering of services, and involve separately identifiable components that are recognized based on relative fair value. This gives rise to the risk that sales could be misstated due to the complexity of the multi-element contracts and the incorrect valuation of the relative fair value elements. Sales in the remaining sectors are generally recognized when the risks and rewards of the underlying products have been transferred to the customer and tend not to have multiple deliverable elements. There is a risk that sales may be deliberately overstated as a result of management override resulting from the pressure management may feel to achieve planned results. The management of the Group focuses on sales as a key performance measure which could create an incentive for sales to be recognized before the risks and rewards have been transferred.

Our audit procedures included, amongst others, assessing the appropriateness of the Company’s revenue recognition accounting policies including those relating to multi-element contracts and assess compliance with the policies in terms of EU-IFRS. We tested the effectiveness of the Company’s controls over calculation of rebates, fair value determination of multi-element sales contracts, and the correct timing of revenue recognition. We also assessed sales transactions taking place before and after year-end to ensure that revenue was recognized in the correct period and assessed the accuracy of the sales recorded, based amongst others on inspection of sales contracts, hand over certificates and hours reported after recognition of revenue. We have assessed the appropriateness of management’s response to indications of improper revenue recognition and performed additional work where considered necessary. We also assessed the adequacy of the sales disclosures contained in Section 12.9, Note 2 Information by sector and main country and Note 6 Income from operations.

Contingent liabilities and provisions from claims, proceedings and investigations

The Company and certain of its group companies and former group companies are involved as a party in legal proceedings, including regulatory and other governmental proceedings as well as investigations by authorities. Since the ultimate disposition of asserted claims and proceedings and investigations cannot be predicted with certainty, an adverse outcome could have a material adverse effect on the financial position, results of operations and cashflows, resulting in the identification of a significant financial statement risk.

The accounting for (contingent) liabilities from claims, proceedings and investigations is complex and judgemental, and the amounts involved are, or can be material to the financial statements as a whole. At December 31, 2014, the provisions from legal proceedings amount to EUR 653 million, in case the company has a present legal or constructive obligation that cannot be estimated reliably, no provisions have been recognized.

In response to these risks, our audit procedures included, amongst others, testing the effectiveness of the Company’s controls around the identification and evaluation of claims, proceedings and investigations at different levels in the organization, and the recording and continuous re-assessment of the related (contingent) liabilities and provisions and disclosures, in accordance with EU-IFRS. We also inquired with both legal and financial staff in respect of ongoing investigations or claims, proceedings and investigations, inspected relevant correspondence, inspected the minutes of the meetings of the Audit Committee, Supervisory Board and Executive Committee, requested external legal confirmation letters from a selection of external legal counsel and obtained a legal representation letter from the Company.

We evaluated and tested the Company’s policies, procedures and controls surrounding the application of the General Business Principles (GBP), the identification and reporting of violations and assessed management’s response to any GBP violations. We also assessed the disclosure regarding (contingent) liabilities from legal proceedings and investigations as contained in Section 12.9, Note 19 Provisions, Note 22 Other Liabilities and Note 26 Contingent assets and liabilities.

Responsibilities of the Board of Management and the Supervisory Board for the financial statements

The Board of Management is responsible for the preparation and fair presentation of the financial statements in accordance with EU-IFRS and Part 9 of Book 2 of the Dutch Civil Code, and for the preparation of the Management report in accordance with Part 9 of Book 2 of the Dutch Civil Code. Furthermore, the Board of Management is responsible for such internal control as the Board of Management determines is necessary to enable the preparation of the financial statements that are free from material misstatement, whether due to fraud or error.

In preparing the financial statements, the Board of Management is responsible for assessing the Company’s ability to continue as a going concern. Based on the financial reporting frameworks mentioned, the Board of Management should prepare the financial statements using the going concern basis of accounting unless the Board of Management either intends to liquidate the Company or to cease operations, or has no realistic alternative but to do so. The Board of Management should disclose events and circumstances that may cast significant doubt on the Company’s ability to continue as a going concern in the financial statements.

The Supervisory Board is responsible for overseeing the Company’s financial reporting process.

Our responsibilities for the audit of the financial statements

Our objective is to plan and perform the audit assignment in a manner that allows us to obtain sufficient and appropriate audit evidence for our opinion.

Our audit has been performed with a high, but not absolute, level of assurance, which means we may have not detected all errors and fraud.

For a further description of our responsibilities in respect of an audit of financial statements in general, we refer to the website of the professional body for accountants in the Netherlands (NBA). www.nba.nl/standardtexts-auditorsreport.

Report on other legal and regulatory requirements

Report on the Management report and the other information

Pursuant to legal requirements under Part 9 of Book 2 of the Dutch Civil Code (concerning our obligation to report about the Management report and other information):

  • We have no deficiencies to report as a result of our examination whether the Management report, to the extent we can assess, has been prepared in accordance with Part 9 of Book 2 of the Dutch Civil Code, and whether the information as required by Part 9 of Book 2 of the Dutch Civil Code has been annexed.
  • We report that the Management report, to the extent we can assess, is consistent with the financial statements.

Appointment

We were appointed before 2008 for the first time as auditor of Koninklijke Philips N.V. and operated as auditor since then. We were re-appointed by the Annual General Meeting of Shareholders as auditor of Koninklijke Philips N.V. on March 31, 2011, for the three year period 2012 – 2014. On May 1, 2014, we were appointed by the Annual General Meeting of Shareholders as auditor of Koninklijke Philips N.V. for the year 2015, after which we will mandatorily rotate off from the Philips audit pursuant to Dutch law.

Amsterdam, The Netherlands

February 24, 2015

KPMG Accountants N.V.

E.H.W. Weusten RA

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