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.

     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

 

 

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
A.		Selected financial data			2
B.		Capitalization and indebtedness			3
C.		Reasons for the offer and use of proceeds			3
D.		Risk factors			3
Item 4.    Information on the Company					9
A.		History and development of the Company			9
B.		Business overview			10
		Products			10
		Marketing and distribution			13
		Service			13
		Net sales by product group and geographic area			14
		Seasonality			15
		Sources of supply			15
		Competition			15
		Patents and licenses			16
		Environmental regulations			17
C.		Organizational structure			19
D.		Property, plants and equipment			20
Item 5.    Operating and Financial Review and Prospects					23
A.		Operating results			23
		Overview			23
		Critical accounting policies and estimates			24
		Consolidated result of operations			26
		Fiscal 2005 compared with fiscal 2004			26
		Fiscal 2004 compared with fiscal 2003			29
		Foreign operations and foreign currency transactions			34
		Recent developments			34
B.		Liquidity and capital resources			34
C.		Research and development, patents and licenses			35
D.		Trend information			36
		Trend information			36
		Forward looking statements			37
E.		Off-balance sheet arrangements			38
F.		Contractual obligations			38
Item 6.    Directors, Senior Management and Employees					39
A.		Directors and senior management			39
B.		Compensation			43
C.		Board practices			44
D.		Employees			44
E.		Share ownership			45
Item 7.    Major Shareholders and Related Party Transactions					46
A.		Major shareholders			46
B.		Related party transactions			46
C.		Interests of experts and counsel			46

				Page number
Item 8.    Financial Information					47
A.		Consolidated financial statements and other financial information			47
		Consolidated financial statements			47
		Legal proceedings			47
		Dividend policy			47
B.		Significant changes			48
Item 9.    The Offer and Listing					48
A.		Offer and listing details			48
		Trading in domestic markets			48
		Trading in foreign markets			49
B.		Plan of distribution			49
C.		Markets			49
Item 10.  Additional Information					50
A.		Share capital			50
B.		Memorandum and articles of association			50
C.		Material contracts			54
D.		Exchange controls			54
E.		Taxation			55
F.		Dividends and paying agents			57
G.		Statement by experts			57
H.		Documents on display			57
I.		Subsidiary information			57
Item 11.  Quantitative and Qualitative Disclosures About Market Risk					57
		Market risk exposures			57
		Equity price risk			58
		Foreign currency exchange rate and interest rate risk			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
		Consolidated Balance Sheets			67
		Consolidated Statements of Income			68
		Consolidated Statements of Stockholders’ Equity			69
		Consolidated Statements of Cash Flows			70
		Notes to Consolidated Financial Statements			71
		Valuation and Qualifying Accounts			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

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.

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:

     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.

     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.

     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.

     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.

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.

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.

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.

     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.

     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.

     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.

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.

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”.

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.

     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)

     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.

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:

     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	%

     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

		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

		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.

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.

-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.

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).

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.

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.

     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

     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.

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.

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.

     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.

     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.

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