**Exhibit 13.1***This Management’s Discussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with the consolidated financial statements, the notes thereto and thehistorical summary appearing elsewhere in this annual report. Historical results and percentagerelationships set forth in the consolidated financial statements, including trends that mightappear, should not be taken as indicative of future operations. The following discussion containsforward-looking statements that involve risks and uncertainties. Our actual results may differmaterially from those discussed in such forward-looking statements as a result of various factors,including those described under the section “Cautionary Statements for Safe Harbor Purposes”included elsewhere in this annual report.***OVERVIEW**GENERALWe are an innovative specialty chemical company that produces and supplies technologies thatimprove the quality and performance of our customers’ products in the global transportation,industrial and consumer markets. Our business is founded on technological leadership. Innovationprovides opportunities for us in growth markets as well as advantages over our competitors. From abase of more than 1,600 patents, we use our product development and formulation expertise tosustain our leading market positions and fuel our future growth. We create additives, ingredients,resins and compounds that enhance the performance, quality and value of our customers’ products,while minimizing their environmental impact. Our products are used in a broad range ofapplications, and are sold into relatively stable markets such as those for engine oils, specialtydriveline lubricants and metalworking fluids, as well as higher-growth markets such as personalcare and over-the-counter pharmaceutical products and performance coatings and inks. Ourengineered polymers products also are used in a variety of industries, including construction,sporting goods, medical products and automotive. We are an industry leader in many of the marketsin which our product lines compete.We are geographically diverse, with an extensive global manufacturing, supply chain, technical andcommercial infrastructure. We operate facilities in 27 countries, including production facilitiesin 19 countries and laboratories in 12 countries, in key regions around the world through theefforts of more than 6,900 employees. We sell our products in more than 100 countries and believethat our customers value our ability to provide customized, high quality, cost-effectiveperformance formulations and solutions worldwide. We also believe that our customers value ourglobal supply chain capabilities.On November 1, 2007, we completed the acquisition of the refrigeration lubricants business of CrodaInternational Plc (Croda) for approximately $124.6 million in cash. The acquisition primarilyincluded lubricant technology, trade names, customer lists, manufacturing know-how and inventory.No manufacturing facilities were included in the transaction. We began consolidating the resultsof the refrigeration lubricants business of Croda in our consolidated financial statements inNovember 2007. Revenues in 2007 for this business, which were included in the company’sconsolidated results, were approximately $8.3 million. The preliminary purchase price allocationfor this acquisition included goodwill of $53.3 million and intangible assets of $64.7 million.On February 7, 2007, we completed the acquisition of a broad line of additive products used in themetalworking markets worldwide from Lockhart Chemical Company (Lockhart) for approximately $15.7million in cash. We purchased Lockhart’s entire metalworking product line, which included natural,synthetic and gelled sulfonates; emulsifier packages; corrosion inhibitors and lubricity agents;grease additives; oxidates; esters; soap; semi-finished coatings; and rust preventatives. We beganconsolidating the results of the metalworking business of Lockhart in our consolidated financialstatements in February 2007. In 2007, these product lines contributed revenues of $16.8 million toour consolidated results. The purchase price allocation for this acquisition included goodwill of$8.3 million and intangible assets of $7.6 million.In May 2006, we sold the food ingredients and industrial specialties business (FIIS) and the activepharmaceutical ingredients and intermediate compounds business (A&I), both of which were includedin the Lubrizol Advanced Materials segment. A&I and almost all of the FIIS divestiture reportedinto the
 

 
Noveon® consumer specialties product line, while a small portion of the FIISdivestiture reported into the performance coatings product line. In 2006, we recorded a $15.9million after-tax loss on the sale of these divested businesses. During the first quarter of 2006and in connection with the held-for-sale classification, we performed an impairment test resultingin a $60.6million after-tax impairment charge in the first quarter of 2006. We have reflected the results ofthese divested businesses in the discontinued operations - net of tax line item in the consolidatedstatements of income for 2006 and 2005.In February 2006, we sold certain assets and liabilities of our Telene® resins business(Telene), which was included in the Lubrizol Advanced Materials segment. We have reflected theresults of Telene in the discontinued operations - net of tax line item in the consolidatedstatements of income for 2006 and 2005, including an after-tax loss on the sale of $0.7 millionrecorded in 2006.In December 2005, we sold certain assets, liabilities and stock of our Engine Control Systems (ECS)business and, in September 2005, we sold certain assets and liabilities of our U.S. and U.K.Lubrizol Performance Systems (LPS) operations, both of which were included in the LubrizolAdditives segment. We have reflected the results of these businesses in the discontinuedoperations - net of tax line item in the consolidated statement of income for 2005.LUBRIZOL ADDITIVES SEGMENTChallenging industry market forces and conditions continue to influence the Lubrizol Additivesbusiness. A key factor is the low global growth rate for this market, which we believe is in therange of approximately 0% to 1% per year. Additional characteristics of this market are: **•** Consolidation of the additive industry and capacity reductions in recent years, whichhas tightened the supply of lubricant additive components and packages.  **•** Frequent product specification changes primarily driven by original equipmentmanufacturers (OEMs) and the impact of environmental and fuel economy regulations on theOEMs. The specification changes require us to incur product development and testing costs,but also enable us to apply our technology know-how to create products and solve problems.We believe our technology, and our expertise in applying it, are key strengths.  **•** Improved engine design, which can result in longer lubricant drain intervals. Longerdrain intervals reduce demand for finished lubricants.  **•** New vehicle production levels, which affect our driveline fluids in particular becausethe initial factory fill is an important market factor in that product line.  **•** In recent years, a general tightening of supplies leading to significant increases inraw material and energy costs.We believe we are the market leader in lubricant additives and intend to remain the leader bycontinuing to invest in this business. Our strategy is to continue to optimize our product linemix with existing production capacity. Our Lubrizol Additives segment represents approximately 66%of consolidated revenues.LUBRIZOL ADVANCED MATERIALS SEGMENTOur Lubrizol Advanced Materials segment’s growth strategy involves a combination of internal growthand acquisitions. Our internal growth strategy in the Lubrizol Advanced Materials segment is touse our strengths, including our technology, formulating skills and broad geographicinfrastructure, to develop and invest in new performance technologies in higher-growth industrialand consumer markets. Key factors to our success continue to be the introduction of new products,development of new applications for existing products, cross-selling of products, the integrationof future acquisitions and geographic expansion. Our Lubrizol Advanced Materials segmentrepresents approximately 34% of consolidated revenues.
 

 
PRIMARY FACTORS AFFECTING 2007 RESULTS FROM CONTINUING OPERATIONSThe factors that most affected our consolidated 2007 results from continuing operations were: **•** Our ability to recover past raw material cost increases, increased operating costs instrategic geographic regions and research and development efforts now and into the futureas we move new technologies into our global manufacturing plants. Raw material costsincreased 7% in 2007 after increasing 14% in 2006. Our results were affected by howquickly and the extent to which we were able to raise selling prices in response to rawmaterial and other cost increases. Both the Lubrizol Additives and Lubrizol AdvancedMaterials segments implemented price increases in 2007 in response to continuing increasesin these costs.  **•** Volume increases of 4% in the Lubrizol Additives segment and 2% in the LubrizolAdvanced Materials segment. In addition, we experienced a favorable currency impact on our2007 revenues of 3% in the Lubrizol Additives segment and 2% in the Lubrizol AdvancedMaterials segment.  **•** Increased operating costs due to an unfavorable currency impact, general salary andbenefit cost increases, the funding of growth resources, increased environmental-relatedcharges, higher maintenance materials and contract labor costs in the Lubrizol Additivessegment primarily in our plants in the U.S. Gulf Coast and Europe, unfavorablemanufacturing cost absorption, costs associated with the implementation of a commoninformation systems platform primarily in the Lubrizol Advanced Materials segment andhigher incentive compensation expense.  **•** A reduction in restructuring and impairment-related charges of $50.4 million as 2006charges included a $41.2 million charge associated with the impairment of the Noveon tradename and a $10.7 million charge related to plant and product line closures in both theLubrizol Additives and Lubrizol Advanced Materials segments.  **•** Reduced interest expense - net of $15.5 million as a result of lower interest expenseof $7.9 million associated with reduced debt levels and higher interest income of $7.6million associated with higher cash and short-term investment balances primarily related toour significant cash flows from operating activities and the cash proceeds from the 2006divestitures.  **•** Reduced effective tax rate primarily due to the favorable resolution of tax mattersfrom prior years, an improvement in our geographic earnings mix as a result of our stronginternational growth and an increase in non-taxable foreign currency translation gainsassociated with international subsidiaries, whose functional currency is the U.S. dollar.**2007 RESULTS OF OPERATIONS COMPARED WITH 2006**Income from continuing operations increased $103.6 million to $283.4 million in 2007 compared with$179.8 million in 2006. The increase in income from continuing operations primarily was due toimprovements in the combination of price and product mix mainly in the Lubrizol Additives segmentas we were able to recover lost margin attributable to past raw material cost increases and wecontinued to increase the value of our customer offerings in this segment. Our 2007 results alsowere impacted favorably by increased volume, lower net interest costs, lower restructuring andimpairment-related charges and the favorable resolution of tax matters from prior years, which morethan offset higher raw material cost, higher manufacturing expenses and increased selling,technology, administrative and research (STAR) expenses.Net income for 2006 included a loss from discontinued operations - net of $76.2 million, whichprimarily related to a $60.6 million after-tax impairment charge recorded in the first quarter of2006 to reflect the FIIS business at its fair value and a $16.6 million after-tax loss on the saleof divested businesses.
 

 
                   Year Ended December 31        *(In Millions of Dollars Except Per Share Data)* 2007  2006  $ Change  % ChangeRevenues $ 4,499.0  $ 4,040.8  $458.2   11%Cost of sales  3,378.1   3,045.2   332.9   11%              Gross profit  1,120.9   995.6   125.3   13%                 Selling and administrative expenses  422.2   381.7   40.5   11%Research, testing and development expenses  218.9   205.5   13.4   7%Amortization of intangible assets  24.3   23.7   0.6   3%Restructuring and impairment charges  1.5   51.9   (50.4)   *Other income- net  (8.8)  (8.5)  (0.3)  4%Interest income  (28.0)  (20.4)  (7.6)  37%Interest expense  91.8   99.7   (7.9)  (8%)              Income from continuing operations beforeincome taxes  399.0   262.0   137.0   52%Provision for income taxes  115.6   82.2   33.4   41%              Income from continuing operations  283.4   179.8   103.6   58%Income (loss) from discontinuedoperations - net of tax  –   (76.2)  76.2    *              Net income $283.4  $103.6  $179.8   174%                               Basic earnings (loss) per share:                Continuing operations $4.10  $2.62  $1.48   56%Discontinued operations  –   (1.11)  1.11    *              Net income per share, basic $4.10  $1.51  $2.59   172%                               Diluted earnings (loss) per share:                Continuing operations $4.05  $2.59  $1.46   56%Discontinued operations  –   (1.10)  1.10    *              Net income per share, diluted $4.05  $1.49  $2.56   172%              *** *Calculation not meaningful****Revenues***The increase in revenues in 2007 compared with 2006 primarily was due to a 5% improvementin the combination of price and product mix, a 4% increase in volume and a 2% favorable currencyimpact. We experienced volume gains in all geographic zones except North America.***Analysis of Volume - 2007 vs. 2006***Volume patterns vary in different geographic zones. Thefollowing table shows the geographic break-down of our volume in 2007 as well as the percentagechanges compared with 2006:           2007    Volume % Change North America  46%  – Europe  26%  5%Asia-Pacific / Middle East  21%  7%Latin America     7%  24%         Total  100%  4%         
 

 
Segment volume variances by geographic zone, as well as the factors explaining the changes insegment revenues for 2007 compared with 2006, are contained within the “Segment Analysis” section.***Cost of Sales***The increase in cost of sales for 2007 compared with 2006 primarily was due tohigher raw material costs, higher manufacturing expenses and increased volumes. Average rawmaterial cost increased 7% in 2007 compared with 2006. Total manufacturing expenses increased 12%in 2007 compared with 2006 primarily due to anunfavorable currency impact, increased volumes, increased salaries and benefits, higher maintenancematerials and contract labor costs in the Lubrizol Additives segment mostly attributable to ourplants in the U.S. Gulf Coast and Europe, increased environmental-related charges and unfavorablemanufacturing cost absorption as we lowered first quarter 2007 production to reduce inventorylevels from the prior year end. The increase in manufacturing expenses partially was offset by adecrease in utility costs. On a per-unit-sold basis, manufacturing costs increased 7% in 2007compared with 2006. Excluding the impact of currency, per-unit manufacturing costs increased 4% in2007 compared with 2006.***Gross Profit***Gross profit increased $125.3 million, or 13%, in 2007 compared with 2006. Theincrease primarily was due to an improvement in the combination of price and product mix and highervolume partially offset by higher average raw material cost and higher manufacturing expenses. Ourgross profit percentage increased to 24.9% in 2007 compared with 24.6% in 2006. This increase wasattributable to an increase in the Lubrizol Additives segment gross profit percentage largely dueto the favorable impact of price and product mix and increased volume, partially offset by adecrease in the Lubrizol Advanced Materials segment gross profit percentage primarily as a resultof higher raw material costs.***Selling and Administrative Expenses***Selling and administrative expenses increased $40.5 million,or 11%, in 2007 compared with 2006. The increase primarily reflects higher salaries and benefitsas a result of annual merit increases and the funding of growth resources, an unfavorable currencyimpact and an increase associated with the implementation of a common information systems platformprimarily in the Lubrizol Advanced Materials segment. In addition, 2006 expenses included a $2.9million pension settlement charge related to a non-qualified pension plan distribution.***Research, Testing and Development Expenses***The timing and amount of research, testing anddevelopment expenses (technology expenses) are affected by lubricant additives product standards,which change periodically to meet new emissions, efficiency, durability and other performancefactors as OEMs improve engine and transmission designs. Technology expenses increased $13.4million, or 7%, in 2007 compared with 2006 primarily due to an unfavorable currency impact and anincrease in annual salaries and benefits. During 2007 and 2006, approximately 88% of ourtechnology costs were incurred in company-owned facilities and approximately 12% were incurred atthird-party facilities.***Restructuring and Impairment Charges***In 2007, we recorded aggregate restructuring and impairmentcharges of $1.5 million primarily related to impairment charges in the Lubrizol Advanced Materialssegment, partially offset by a gain recorded on the sale of a Lubrizol Additives manufacturingfacility located in Bromborough, United Kingdom. We received net cash proceeds of $5.9 million andrecorded a pretax gain of $2.8 million upon closing of the sale in January 2007.The components of the 2007 restructuring and impairment charges are detailed as follows:                       Asset Other Plant       *(In Millions of Dollars)* Impairments Exit Costs Severance TotalLubrizol Advanced Materials plant closures,production line impairments and workforce reductions  $ 3.4   $ 0.2   $ 0.5   $ 4.1 Bromborough, U.K. plant closure and sale   (2.8)   0.1    –    (2.7)Corporate / other workforce reductions   –    –    0.1    0.1                  Total restructuring and impairment charges  $ 0.6   $ 0.3   $ 0.6   $ 1.5                  ***OtherIncome - Net***Other income - net of $8.8 million in 2007 primarily consisted of a $5.0million gain recorded on the sale of land and a favorable currencyimpact. Other income - net of$8.5 million in 2006
 

 
primarily was comprised of favorable legal settlements of insurance andcommercial matters of $11.6 million.***InterestExpense - Net***The decrease in interest expense - net in 2007 compared with 2006 primarilywas due to lower interest expense of $7.9 million associated with our reduced debt balances and anincrease in interest income of $7.6 million as a result of our increased cash and short-terminvestment balances primarily related to our significant cash flows from operating activities andfrom the divestiture proceeds received in May 2006.***Provision for Income Taxes***Our effective tax rate was 29.0% in 2007 compared with 31.4% in 2006.The decrease in the effective tax rate primarily was due to the favorable resolution of tax mattersfrom prior years, an improvement in our geographic earnings mix as a result of our stronginternational growth and an increase in non-taxable foreign currency translation gains associatedwith international subsidiaries, whose functional currency is the U.S. dollar.***Income from Continuing Operations***Primarily as a result of the above factors, income fromcontinuing operations per diluted share increased 56% to $4.05 in 2007 compared with $2.59 in 2006.***Net Income***Net income in 2006 included a loss from discontinued operations per diluted share of$1.10, which consisted of operating income of $0.01 per diluted share, excluding an $0.87 perdiluted share non-cash impairment charge and a $0.24 per diluted share loss on the sale of divestedbusinesses.**2006 RESULTS OF OPERATIONS COMPARED WITH 2005**Income from continuing operations increased $20.4 million to $179.8 million for 2006 compared with$159.4 million for 2005. The increase in earnings from continuing operations primarily wasattributable to improvements in the combination of price and product mix, higher volume and reducedinterest expense - net, which more than offset higher raw material and utility costs, higherrestructuring and impairment charges and higher STAR expenses.We recorded restructuring and impairment charges that reduced income from continuing operations by$0.47 per diluted share in 2006, which primarily related to a pretax impairment charge associatedwith the Noveon trade name and the phase-out of a manufacturing facility located in Bromborough,United Kingdom. We incurred restructuring and impairment charges of $0.15 per diluted share in2005, which primarily related to the phase-out of manufacturing facilities located in Bromborough,United Kingdom; Linden, New Jersey; and Mountaintop, Pennsylvania, as well as other workforcereductions.Net income for 2006 included the factors described above for income from continuing operations andthe impact of discontinued operations. Loss from discontinued operations - net was $76.2 millionin 2006 compared with income from discontinued operations - net of $27.8 million in 2005. The lossfrom discontinued operations - net in 2006 primarily related to a $60.6 million after-taximpairment charge recorded in the first quarter of 2006 to reflect the FIIS business at its fairvalue and a $16.6 million after-tax loss on the sale of divested businesses.
 

 
                   Year Ended December 31          *(In Millions of Dollars Except Per Share Data)* 2006  2005  $ Change  % Change Revenues $ 4,040.8  $ 3,622.2  $ 418.6   12% Cost of sales  3,045.2   2,700.1   345.1   13%               Gross profit  995.6   922.1   73.5   8%                  Selling and administrative expenses  381.7   348.4   33.3   10% Research, testing and development expenses  205.5   198.9   6.6   3% Amortization of intangible assets  23.7   23.5   0.2   1% Restructuring and impairment charges  51.9   15.9   36.0   * Other income - net  (8.5)  (1.8)  (6.7)  * Interest income  (20.4)  (8.1)  (12.3)  * Interest expense  99.7   105.1   (5.4)  (5%)              Income from continuing operations beforeincome taxes  262.0   240.2   21.8   9% Provision for income taxes  82.2   80.8   1.4   2%              Income from continuing operations  179.8   159.4   20.4   13% (Loss) income from discontinuedoperations - net of tax  (76.2)  27.8   (104.0)  *               Net income $ 103.6  $ 187.2  $ (83.6)  (45%)                               Basic earnings (loss) per share:                Continuing operations $ 2.62  $ 2.35  $ 0.27   11% Discontinued operations  (1.11)  0.41   (1.52)  *               Net income per share, basic $ 1.51  $ 2.76  $ (1.25)  (45%)                               Diluted earnings (loss) per share:                Continuing operations $ 2.59  $ 2.32  $ 0.27   12% Discontinued operations  (1.10)  0.40   (1.50)  *               Net income per share, diluted $ 1.49  $ 2.72  $ (1.23)  (45%)               * *Calculation not meaningful****Revenues***The increase in revenues in 2006 compared with 2005 primarily was due to an 11%improvement in the combination of price and product mix and a 1% increase in volume. Weexperienced volume gains in Asia-Pacific / Middle East and Latin America.***Analysisof Volume - 2006 vs. 2005***Volume patterns vary in different geographic zones. Thefollowing table shows the geographic break-down of our volume in 2006 as well as the percentagechanges compared with 2005:           2006    Volume % ChangeNorth America  48%  – Europe  26%  (1%)Asia-Pacific / Middle East  21%  6%Latin America  5%  11%         Total  100%  1%         Segment volume variances by geographic zone, as well as the factors explaining the changes insegment revenues for 2006 compared with 2005, are contained within the “Segment Analysis” section.
 

 
***Cost of Sales***The increase in cost of sales for 2006 compared with 2005 primarily was due tohigher average raw material cost and higher manufacturing expenses. Average raw material costincreased 14% in 2006 compared with 2005 primarily due to higher petrochemical raw material cost.Total manufacturing expenses increased 4% in 2006 compared with 2005, primarily due to highersalaries and benefits, higher utility costs and increased volume. On a per-unit-sold basis,manufacturing costs increased 2% in 2006 compared with 2005.***Gross Profit***Gross profit increased $72.5 million, or 8%, in 2006 compared with 2005. Theincrease primarily was due to an improvement in the combination of price and product mix and highervolume partially offset by higher average raw material cost. In addition, gross profit wasimpacted unfavorably by higher salaries and benefits, an increase in utility costs and anunfavorable currency impact in 2006 when compared with 2005. Although we were successful inraising selling prices to offset higher cost of sales, our 2006 gross profit percentage decreasedto 24.6% compared with 25.5% in 2005 due to the increase in net sales from our pricing responses toescalating raw material costs.***Selling and Administrative Expenses***Selling and administrative expenses increased $33.3 million,or 10%, in 2006 compared with 2005. The increase primarily reflects an increase in salaries andbenefits including the addition of growth resources, an increase of $4.5 million associated with anewly commenced project to implement a common information systems platform primarily in theLubrizol Advanced Materials segment, the unfavorable impact of variable accounting for some of ourliability-based incentive plans, a $2.9 million pension settlement charge for a non-qualifiedpension plan distribution and incremental stock-based compensation expense of $2.4 millionassociated with the adoption of Statement of Financial Accounting Standards (SFAS) No. 123R.***Research, Testing and Development Expenses***The timing and amount of research, testing anddevelopment expenses are affected by lubricant additives product standards, which changeperiodically to meet new emissions, efficiency, durability and other performance factors as OEMsimprove engine and transmission designs. Technology expenses increased $6.6 million, or 3%, in2006 compared with 2005 primarily due to increases in annual salaries and benefits. During 2006and 2005, approximately 87% of our technology costs were incurred in company-owned facilities andapproximately 13% were incurred at third-party facilities.***Restructuring and Impairment Charges***In 2006, we recorded aggregate restructuring and impairmentcharges of $51.9 million, or $0.47 per diluted share, primarily related to the write-down of atrade name in the Lubrizol Advanced Materials segment and the phase-out of a manufacturing facilityin the Lubrizol Additives segment.The components of the 2006 restructuring and impairment charges are detailed as follows:                   Asset Other Plant    *(In Millions of Dollars)* Impairments Exit Costs Severance TotalNoveon trade name impairment $ 41.2  $    –  $    –  $ 41.2 Bromborough, U.K. plant closure  –   4.8   1.9   6.7 Lubrizol Advanced Materials plant and line closuresand workforce reductions  3.3   0.2   0.6   4.1 Other  –   –   (0.1)  (0.1)                 Total restructuring and impairment charges $ 44.5  $ 5.0  $ 2.4  $ 51.9                  As part of our corporate goal to enhance our “one company” identity and to reflect more accuratelyour positioning in the marketplace, we completed a corporate identity review in the fourth quarterof 2006. We made a final determination in January 2007 that the trade name “Noveon” no longerwould be used to describe the Lubrizol Advanced Materials segment of our company and that its usewould be discontinued except in connection with our consumer specialties product line. We acquiredthe rights to the Noveon trade name in June 2004 when we acquired Noveon International, Inc.(Noveon International). At the time of acquisition, an appraised value was attached to the Noveontrade name. We calculated a pretax charge of $41.2 million ($25.4 million after tax) to reduce therelated asset to its estimated fair value. This charge
 

 
was reflected in the fourth quarter of 2006as we believed at that time we would more likely than not discontinue the use of the Noveon tradename, except in the limited context of our consumer specialties product line.In September 2006, we entered into an agreement to sell the manufacturing facility located inBromborough, United Kingdom. The sale closed in January 2007. In connection with the sale, wereceived net cash proceeds of $5.9 million and recorded a pretax gain of $2.8 million during thefirst quarter of 2007. The gain was classified as a reduction to restructuring charges associatedwith closure of the facility. Production from the Bromborough facility was transferred tohigher-capacity Lubrizol facilities in France and the United States. The sale of the facilityavoided approximately $3.0 million to $5.0 million in restructuring costs that would have beenassociated with demolition of the plant facilities on the site. On January 17, 2005, we announcedour plans to phase-out production at the Bromborough facility by the end of 2006. At that time, weestimated that total restructuring costs, including employee severance and other plant closurecosts (including planned demolition costs), would be approximately $15.0 million. Cumulativepretax charges of approximately $12.8 million were incurred through 2006, of which $6.7 millionwere incurred in 2006, to satisfy severance and retention obligations, plant dismantling, siterestoration and other site environmental evaluation costs. We invested approximately $15.3 millionin capital related to the Bromborough closure through December 31, 2006 for capacity upgrades inFrance and the United States.In the first quarter of 2005, we decided to close two Lubrizol Advanced Materials performancecoatings production facilities in the United States. One facility, located in Mountaintop,Pennsylvania, was closed in October 2005 and sold in January 2006. We recorded an additional $0.8million in asset impairments and other exit costs and $0.6 million in severance obligations in 2006relating to the other facility located in Linden, New Jersey, which was closed in the third quarterof 2006. Additional asset impairment charges of $2.7 million were recorded in 2006, whichprimarily related to the planned closure of a performance coatings production line in the firstquarter of 2007.***Other Income - Net***The increase in other income - net for 2006 compared with 2005 primarily wasdue to the favorable legal settlements of insurance and commercial matters of $11.6 million and anincrease in the net gain on the sale of property of $1.3 million, partially offset by an increasein currency transaction losses of $2.4 million and an increase in the elimination of minorityinterest of $2.4 million due to higher profitability of our joint ventures.***Interest Expense - Net***The decrease in interest expense - net for 2006 compared with 2005primarily was due to an increase in interest income of $12.3 million as a result of our increasedcash and short-term investments from the divestiture proceeds and a decrease in interest expense of$5.4 million due to a reduction in our long-term debt balances.***Provision for Income Taxes***Our effective tax rate was 31.4% in 2006 compared with 33.6% in 2005.The decrease in the effective tax rate primarily was due to the favorable provision impacts offoreign operations.***Income from Continuing Operations***Primarily as a result of the above factors, income fromcontinuing operations per diluted share was $2.59 in 2006 compared with $2.32 in 2005.***Net Income***Net income included a loss from discontinued operations per diluted share of $1.10 in2006 compared with income from discontinued operations per diluted share of $0.40 in 2005. Theloss from discontinued operations per diluted share of $1.10 in 2006 consisted of operating incomeof $0.01 per diluted share, excluding an $0.87 per diluted share impairment charge and a $0.24 perdiluted share loss on the sale of divested businesses.**SEGMENT ANALYSIS**We primarily evaluate performance and allocate resources based on segment operating income, definedas revenues less expenses identifiable to the product lines included within each segment, as wellas projected future returns. Segment operating income will reconcile to consolidated income fromcontinuing
 

 
operations before income taxes by deducting corporate expenses and corporate otherincome (expense) that are not attributable to the operating segments, restructuring and impairmentcharges and net interest expense.The proportion of consolidated revenues and segment operating income attributed to each segment wasas follows:               2007 2006 2005**Revenues:**            Lubrizol Additives  66%  64%  63%Lubrizol Advanced Materials  34%  36%  37%             **Segment Operating Income:**            Lubrizol Additives  73%  64%  64%Lubrizol Advanced Materials  27%  36%  36%**OPERATING RESULTS BY SEGMENT**                                           2007 vs. 2006  2006 vs. 2005 *(In Millions of Dollars)* 2007  2006  2005  $ Change  % Change  $ Change  % Change Revenues:                            Lubrizol Additives $ 2,961.1  $ 2,600.5  $ 2,280.0  $ 360.6   14%  $ 320.5   14% Lubrizol Advanced Materials  1,537.9   1,440.3   1,342.2   97.6   7%   98.1   7%                         Total $ 4,499.0  $ 4,040.8  $ 3,622.2  $ 458.2   11%  $ 418.6   12%                                                      Gross Profit:                            Lubrizol Additives $ 704.7  $ 581.2  $ 531.0  $ 123.5   21%  $ 50.2   9% Lubrizol Advanced Materials  416.2   414.4   391.1   1.8   –       23.3   6%                         Total $ 1,120.9  $ 995.6  $ 922.1  $ 125.3   13%  $ 73.5   8%                                                      Segment Operating Income:                            Lubrizol Additives $ 391.0  $ 303.0  $ 263.3  $ 88.0   29%  $ 39.7   15% Lubrizol Advanced Materials  141.8   167.6   150.9   (25.8)  (15%)  16.7   11%                         Total $ 532.8  $ 470.6  $ 414.2  $ 62.2   13%  $ 56.4   14%                         **LUBRIZOL ADDITIVES SEGMENT*****2007 COMPARED WITH 2006******Revenues***Revenues increased 14% in 2007 when compared with 2006. The increase was due to a 7%improvement in the combination of price and product mix, a 4% increase in volume and a 3% favorablecurrency impact. This increase includes the impact of acquisitions, which contributed 1% to thevolume increase in 2007.
 

 
Volume patterns vary in different geographic zones. The following table shows the geographicbreak-down of our volume in 2007 as well as the percentage changes compared with 2006:           2007    Volume % ChangeNorth America  36%  - Europe  31%  6%Asia-Pacific / Middle East  26%  4%Latin America  7%  24%         Total  100%  4%         Volume in 2007 established a record primarily due to business gains in Europe, Asia-Pacific /Middle East and Latin America. North America volumes were level when compared with 2006 as ourdecision to exit low margin fuel additive business was offset by stronger customer demand in otherproduct areas.***Gross Profit***Gross profit increased $123.5 million, or 21%, in 2007 compared with 2006 as wecontinued to recover margin lost in prior periods. The Lubrizol Additives segment implemented aseries of price increases in 2005 and 2006 in response to continued raw material and manufacturingcost increases. The effective dates of the selling price increases varied by geographic saleszone. Gross profit improved primarily due to the combination of price and product mix, increasedvolume and a favorable currency impact, partially offset by a 6% increase in average material costin 2007 as compared with 2006. Manufacturing costs on a per-unit-sold basis increased 9% in 2007compared with 2006 primarily due to higher manufacturing costs for maintenance materials andcontract labor costs mostly attributable to our plants in the U.S. Gulf Coast and Europe, anunfavorable currency impact and higher environmental-related charges. These cost increasespartially were offset by lower utility costs. In addition, we experienced unfavorablemanufacturing cost absorption as we lowered first quarter production to reduce inventory levelsfrom the prior year end.The gross profit percentage increased to 23.8% in 2007 compared with 22.3% in 2006. The increasein gross profit percentage primarily related to the improvements in the combination of price andproduct mix, increased volume and a favorable currency impact.***Selling, Technical, Administrative and Research Expenses***STAR expenses increased 10% in 2007compared with 2006. Selling and administrative costs increased $22.0 million primarily from anunfavorable currency impact and increased incentive compensation expense. In addition, technicalexpenses increased $6.6 million primarily due to higher fuel and test part costs and an unfavorablecurrency impact.***Other Income - Net***Other income in 2007 included a $5.0 million gain on the sale of land recordedin the first quarter of 2007, while other income in 2006 was impacted favorably by $10.4 milliondue to legal settlements of insurance and commercial matters as well as a $1.5 million gain on thesale of certain properties.***Segment Operating Income***Segment operating income increased 29% in 2007 compared with 2006 due tothe factors discussed above.***2006 COMPARED WITH 2005******Revenues***Revenues increased 14% in 2006 when compared with 2005. The increase primarily was dueto an improvement in the combination of price and product mix, while a slight increase in volumewas offset by a slight unfavorable impact of currency.
 

 
Volume patterns vary in different geographic zones. The following table shows the geographicbreak-down of our volume in 2006 as well as the percentage changes compared with 2005:           2006    Volume % ChangeNorth America  38%  1%Europe  30%  (3%)Asia-Pacific / Middle East  26%  2%Latin America  6%  6%         Total  100%  –          Volume increased slightly in 2006 compared with 2005; however, excluding the impact ofnonrecurring, temporary business gains in 2005, volume increased 2% in 2006 compared with 2005.The decrease in volume in Europe was due in part to a change in a customer sourcing from Europe toNorth America. The volume growth in the Asia-Pacific / Middle East region primarily resulted fromgrowth in China, which represented our third largest country in terms of volume sold despite thefact that a majority of the 2005 temporary business gains occurred in this region. The volumegrowth in Latin America primarily was driven by stronger demand by our major internationalcustomers.***Gross Profit***Gross profit increased 9% in 2006 compared with 2005 as we continued to recover frommargin erosion that occurred in 2005 and prior years. The Lubrizol Additives segment implemented aseries of price increases in 2006 and 2005 in response to continued raw material and utility costincreases. The effective dates of the selling price increases varied by geographic zone. Thegross profit increase primarily was due to an improvement in the combination of price and productmix partially offset by a 19% increase in average material cost in 2006 as compared with 2005.Manufacturing costs on a per-unit-sold basis increased 3% in 2006 compared with 2005. The increasewas due in part to higher utility costs as well as higher operating supplies and outside servicespartially offset by lower depreciation expense, employee benefits and a reclassification of certainexpenses from manufacturing to STAR due to a change in organization structure in our Europeanoperations. In addition, manufacturing costs were impacted favorably by approximately $5.2 millionin 2006 as we curtailed production activity at our Bromborough, U.K. plant in accordance with ourpreviously announced timetable to close this facility.The gross profit percentage declined to 22.3% in 2006 compared with 23.3% in 2005. The decline ingross profit percentage primarily was due to continuing raw material cost increases throughout mostof 2006 outpacing the timing of price increases.***Selling, Technical, Administrative and Research Expenses***STAR expenses increased 7% in 2006compared with 2005. This increase primarily was due to an increase in selling and administrativeexpenses of $14.8 million. The higher selling and administrative costs primarily resulted from theimpact of reclassifying to STAR certain expenses that previously were classified as manufacturingresulting from a change in organization structure in our European operations, increases in base andvariable compensation and a change in the timing of annual salary increases. The balance of thechange in STAR expenses was due to an increase in technical expenses of $3.5 million primarilyassociated with technical programs within our driveline and industrial oils additives packages.***Other Income - Net***Other income was impacted favorably by $10.4 million due to legal settlementsof insurance and commercial matters as well as a $1.5 million gain on the sale of certainproperties.***Segment Operating Income***Segment operating income increased 15% in 2006 compared with the prioryear due to the factors discussed above.
 

 
**LUBRIZOL ADVANCED MATERIALS SEGMENT*****2007 COMPARED WITH 2006******Revenues***Revenues for the Lubrizol Advanced Materials segment increased 7% in 2007 compared with2006. The increase was due to a 3% improvement in the combination of price and product mix, a 2%increase in volume and a 2% favorable currency impact.Volume patterns vary in different geographic zones. The following table shows the geographicbreak-down of our volume in 2007 as well as the percentage changes compared with 2006:           2007    Volume % Change North America  67%  (1%)Europe  17%  2%Asia-Pacific / Middle East  12%  19%Latin America  4%  21%         Total  100%  2%         In the first quarter of 2007, we made a minor change to improve the consistency of our reporting ofshipment volumes. Volume in our performance coatings product line, and to a much lesser extent,our Noveonconsumer specialties product line, was reported previously on a dry basis, orexcluding the carrier fluid that is shipped with the base performance material. We are nowreporting all product lines on an “as shipped” basis, including carrier fluid that is blended withthe base material. This change has been reflected for all periods presented.Volume in North America decreased 1% in 2007 compared with 2006 as increases in our engineeredpolymers and Noveon consumer specialties product lines were more than offset by a decrease in ourperformance coatings product line. The increase in our Noveon consumer specialties product linewas due to increased customer demand in our surfactants business and personal care applications.Volume in our engineered polymers product line increased due to strong demand in fire sprinkler andindustrial applications. Volume in our performance coatings product line decreased due to reducedcustomer demand in textiles and inks applications.Volume in Europe increased 2% in 2007 compared with 2006 as increases in our engineered polymersand Noveon consumer specialties product lines more than offset a decrease in our performancecoatings product line. The increase in our engineered polymers product line primarily was due toincreased customer demand in industrial and plumbing applications. Volume in our Noveon consumerspecialties product line increased due to strong demand in personal care and pharmaceuticalapplications. Volume in our performance coatings product line decreased due to reduced customerdemand in inks applications.Volume in Asia-Pacific / Middle East increased 19% in 2007 compared with 2006 with increases in allof our product lines. This increase was due to strong customer demand in geophysical, fiber,plumbing, industrial, paints and coatings, inks, textiles, personal care and explosivesapplications.Volume in Latin America increased 21% in 2007 compared with 2006 with increases in all of ourproduct lines. The volume increase primarily was attributable to increased customer demand inplumbing, explosives, personal care and paints and coatings applications.***Gross Profit***Gross profit increased $1.8 million in 2007 compared with 2006. The slight increasein segment gross profit in 2007 primarily was due to an improvement in the combination of price andproductmix and increased volume, offset by higher average raw material cost and manufacturing expenses.Average raw material cost increased 7% in 2007 compared with 2006. Manufacturing costs increased
 

 
primarily due to increased compensation expense, an unfavorable currency impact and higher volume.Manufacturing costs on a per-unit-sold basis increased 5% in 2007 compared with 2006.The gross profit percentage for this segment was 27.1% in 2007 compared with 28.8% in 2006. Thedecrease in gross profit percentage in 2007 was due to higher average raw material cost andmanufacturing expenses.***Selling, Technical, Administrative and Research Expenses***STAR expenses increased $25.7 million, or11%, in 2007 compared with 2006. The increase in STAR was due to increased headcount to supportour growth strategy, an unfavorable currency impact, higher compensation expense and higher costsassociated with the implementation of a common information systems platform.***Segment Operating Income***Segment operating income decreased 15% in 2007 compared with 2006. Thedecrease in segment operating income primarily was due to the factors discussed above.***2006 COMPARED WITH 2005******Revenues***Revenues for the Lubrizol Advanced Materials segment increased 7% in 2006 compared with2005. The increase was due to a 4% improvement in the combination of price and product mix and a3% increase in volume. The improvement in the combination of price and product mix primarilyoccurred in our Noveon consumer specialties product line.Volume patterns vary in different geographic zones. The following table shows the geographicbreak-down of our volume in 2006 as well as the percentage changes compared with 2005:           2006    Volume % Change North America  69%  (1%)Europe  17%  5%Asia-Pacific / Middle East  10%  28%Latin America  4%  32%         Total  100%  3%         Our performance coatings product line had a slight decrease in volume in North America in 2006compared with 2005, which we believe primarily was due to the continued migration of the textileindustry from North America to China. Our engineered polymers and Noveon consumer specialtiesproduct lines both had increases in volume in North America in 2006 compared with 2005. Theincrease in our engineered polymers product line was due to increased customer demand in both ourEstane® thermoplastic polyurethane business (Estane) and our TempRite®engineered polymers business (TempRite). TempRite benefited from continued conversions from metalsto plastics. The increase in the Noveon consumer specialties product line primarily was due toincreased customer demand in our personal care and home care businesses and tolling sales to thebuyer of our FIIS business.Our engineered polymers and performance coatings product lines had increases in Europe in 2006compared with 2005. The increase in our performance coatings product line primarily was due tocustomer demand and market share gains in the textiles market and customer demand in the paints andcoatings market. The increase in our engineered polymers product line was due to market-sharegains in our Estane business and business gains in our TempRite business resulting from continuedconversions from metals to plastics. Our Noveon consumer specialties product line had a decreasein volume in Europe in 2006 compared with 2005 primarily attributable to our AMPS®specialty monomers business. The increase in Asia-Pacific / Middle East volume for 2006 primarilywas due to higher customer demand and market-share gains in both our Estane business and performance coatings product line, predominately in thetextiles market, and higher customer demand in our Noveon consumer specialties product line. Wealso experienced higher customer demand in the TempRite business, particularly in the Middle Eastand India.
 

 
***Gross Profit***Gross profit increased $23.3 million, or 6%, in 2006 compared with 2005. Theincrease in segment gross profit in 2006 primarily was the result of higher revenues due to theincrease in volume and improvement in the combination of price and product mix partially offset byhigher average raw material cost and manufacturing costs. Average raw material cost increased 4%in 2006 compared with 2005. Manufacturing costs primarily were higher due to increased utilitycosts, the impact of reclassifying certain expenses from STAR to manufacturing as a result of achange in organizational structure in our European operations and higher volume.The gross profit percentage for this segment was 28.8% in 2006 compared with 29.1% in 2005. Thedecrease in gross profit percentage in 2006 was due to higher average raw material cost partiallyoffset by an improvement in the combination of price and product mix.***Selling, Technical, Administrative and Research Expenses***STAR expenses increased $9.0 million, or4%, in 2006 compared with 2005. The increase in STAR was due to higher salaries and incentivecompensation and increased hiring to support growth initiatives partially offset by the impact ofreclassifying certain expenses from STAR to manufacturing as a result of a change in organizationalstructure in our European operations and reductions in bad debt expense.***Segment Operating Income***Segment operating income increased 11% in 2006 compared with 2005. Theincrease in segment operating income primarily was due to the increase in segment gross profit asdescribed above, partially offset by the increase in STAR expenses.**WORKING CAPITAL, LIQUIDITY AND CAPITAL RESOURCES****SELECTED MEASURES OF LIQUIDITY AND CAPITAL RESOURCES**The following table summarizes our financialperformance indicators of liquidity:               2007 2006 Cash and short-term investments (in millions ofdollars) $502.3  $575.7 Working capital (in millions of dollars) $962.6  $1,201.9 Current ratio  2.1   2.9 Debt as a % of capitalization  42.2%  47.8%Net debt as a % of capitalization  32.1%  36.5%**SUMMARY OF CASH FLOWS**The following table summarizes the major components of cash flows:             *(In Millions of Dollars)* 2007  2006  2005  Cash provided by (used for):            Operating activities $476.4  $334.8  $362.2 Investing activities  (309.8)  151.4   (106.8)Financing activities  (260.0)  (183.9)  (312.8)Effect of exchange-rate changes on cash  20.0   11.0   (16.1)          Net (decrease) increase in cash and short-term investments $(73.4) $313.3  $(73.5)          OPERATING ACTIVITIESCash provided by operating activities increased $141.6 million in 2007 compared with 2006. Theincrease in cash provided by operating activities primarily related to an increase in net incomeand an improvement in working capital levels. Specifically, we focused our efforts toward reducinginventory levels and our accounts payable improved due to the timing of raw material purchases andcash disbursements. Inaddition, the accounts payable we retained at the closing of the FIIS divestiture had anunfavorable impact of $27.0 million to operating cash flows in 2006. We also improved thetimeliness of our cash collections, which partially offset our increase in accounts receivableassociated with higher revenues.
 

 
We manage our levels of inventories and accounts receivable on the basis of average days sales ininventory and average days sales in receivables. Our goal is to minimize our investment ininventories while at the same time ensuring reliable supply for our customers. Our average dayssales in inventory improved to 76.6 days for the year ended December 31, 2007 from 80.9 days forthe year ended December 31, 2006. Our average days sales in receivables improved to 47.2 days forthe year ended December 31, 2007 from 48.7 days for the year ended December 31, 2006.INVESTING ACTIVITIESOn February 7, 2007, we used $15.7 million to acquire assets from Lockhart. On November 1, 2007,we used $124.6 million to acquire assets from Croda.Our capital expenditures in 2007 were $182.8 million, as compared with $130.9 million and $136.7million in 2006 and 2005, respectively. Capital expenditures increased in 2007 as we increased ourproduction capacity in our Lubrizol Advanced Materials product lines in China, North America andEurope to meet growing demand and continued our project to bring both segments onto a commoninformation systems platform. Capital expenditures for the Lubrizol Additives segment primarilyare made to maintain existing manufacturing capacity and plant infrastructure. Approximately 35%of the capital expenditures in the Lubrizol Advanced Materials segment related to increasingcapacity. In 2008, we estimate annual capital expenditures will be approximately $215.0 million to$225.0 million.The sales of FIIS and A&I were completed on May 1, 2006 and May 23, 2006, respectively. Inconsideration for these divested businesses, we received net cash proceeds of approximately $254.8million and $10.4 million, respectively. The FIIS sale resulted in a taxable gain, which wasoffset by our net operating loss carryforwards. The sale of Telene was completed in February 2006for net cash proceeds of $6.2 million.FINANCING ACTIVITIESCash used for financing activities increased $76.1 million in 2007 compared with 2006. Cash usedfor financing activities of $260.0 million in 2007 primarilyconsisted of the repayment of €85.0million against our €250.0 million revolving credit agreement, which repaid our euro creditfacility in full, the repurchase of common shares and the payment of dividends, partially offset byproceeds from the exercise of stock options. This compares to $183.9 million used for financingactivities in 2006, which primarily consisted of net repayments of long-term debt and the paymentof dividends, partially offset by proceeds from the exercise of stock options.CAPITALIZATION AND CREDIT FACILITIESAt December 31, 2007, our total debt outstanding of $1,428.8 million consisted of 72% fixed-ratedebt and 28% variable-rate debt, including $400.0 million of fixed-rate debt that effectively hasbeen swapped to a variable rate. Our weighted-average interest rate at December 31, 2007 wasapproximately 5.6%.Our net debt to capitalization ratio at December 31, 2007 was 32.1%. Net debt represents totalshort-term and long-term debt, excluding original issue discounts and unrealized gains and losseson derivative instruments designated as fair-value hedges of fixed-rate debt, reduced by cash andshort-term investments. Capitalization is calculated as shareholders’ equity plus net debt. Totaldebt as a percent of capitalization was 42.2% at December 31, 2007.Our ratio of current assets to current liabilities was 2.1 and 2.9 at December 31, 2007 and 2006,respectively. The decrease in our current ratio from December 31, 2006 to December 31, 2007primarily was related to the reclassification of $204.9 million from long-term to short-term debt.On September 20, 2006, we amended our five-year unsecured committed U.S. bank credit agreement toreduce the revolving credit facility from $500.0 million to $350.0 million and extend the maturitydate to September 2011. In addition, as of September 20, 2006, our direct and indirect domesticsubsidiaries were
 

 
released as guarantors under the credit agreement and we no longer are subject toany investment or acquisition restrictions. This credit facility allows us to borrow at variablerates based upon the U.S. prime rate or LIBOR plus a specified credit spread. At December 31,2007, we had no outstanding borrowings under this agreement.In addition, at December 31, 2007, two of our wholly owned foreign subsidiaries had a €250.0million revolving credit facility that matures in September 2010. This credit agreement permitsthese foreign subsidiaries to borrow at variable rates based on EURIBOR plus a specified creditspread. We have guaranteed all obligations of the borrowers under the credit agreement. OnSeptember 20, 2006, we amended this credit agreement such that we no longer are subject to anyinvestment or acquisition restrictions. No other terms or conditions of the agreement weremodified. At December 31, 2007, we had no borrowings under this agreement.The cash and short-term investments balance of $502.3 million at December 31, 2007 will be used tofund ongoing operations, pay down debt, pursue acquisition opportunities and buy back shares. Given thecall premium on our long-term debt, it is unlikely that we will reduce debt significantly beforeour next scheduled maturity in late 2008. We have no debt that is prepayable without incurring apenalty. Therefore, it is possible that we will carry excess cash until our next scheduledmaturity.CONTRACTUAL CASH OBLIGATIONSThe following table shows our contractual cash obligations under debt agreements, leases,non-cancelable purchase commitments and other long-term liabilities at December 31, 2007:                                               Payments Due by Period*(In Millions of Dollars)*    Total    2008    2009 - 2010    2011 - 2012    2013 and After Total debt (1)     $ 1,433.3      $ 200.3      $382.5      $0.5      $ 850.0 Interest (2)      873.7       80.9       120.7       103.0       569.1 Operating leases      66.8       18.9       30.6       13.5       3.8 Non-cancelable purchasecommitments (3)      177.1       93.2       74.4       5.9       3.6 Other long-termliabilities (4)(5)      66.4       37.5       8.1       0.4       20.4                                     Total contractual cashobligations     $2,617.3      $430.8      $616.3      $123.3      $ 1,446.9                                     (1) Total debt includes both the current and long-term portions of debt as reported in Note 7 tothe consolidated financial statements, excluding original issue discounts and unrealized gainson derivative instruments designated as fair-value hedges of fixed-rate debt. (2) Represents estimated contractual interest payments for fixed-rate debt only. We are not ableto estimate reasonably the cash payments for interest associated with variable-rate debt dueto the significant estimation required relating to both market interest rates as well asprojected principal payments. (3) Non-cancelable purchase commitments primarily include raw materials purchased undertake-or-pay contracts, drumming, warehousing and service contracts, utility purchaseagreements, terminal agreements and toll processing arrangements. (4) Other long-term liabilities disclosed in the table represent long-term liabilities reportedin our consolidated balance sheet at December 31, 2007 under “noncurrent liabilities,”excluding pension,postretirement, postemployment, environmental and other non-contractual liabilities. AtDecember 31, 2007, we had gross unrecognized tax benefits of $59.3 million relating to uncertaintax positions. Due to the high degree of uncertainty regarding the timing of future cashoutflows associated with these tax positions, we are unable to estimate when cash settlement mayoccur. (5) We are required to make minimum contributions to our U.S. qualified defined benefit pensionplans pursuant to the minimum funding requirements of the Internal Revenue Code of 1986, asamended, and the Employee Retirement Income Security Act of 1974, as amended. Fundingrequirements for plans
 

 
  outside the United States are subject to applicable local regulations.In 2008, we expect to make employer contributions of approximately $30.5 million to thequalified plans to satisfy these minimum statutory funding requirements. In 2008, we expectto make payments of approximately $1.6 million relating to our unfunded pension plans. Theexpected payments associated with the unfunded plans represent an actuarial estimate of futureassumed payments based upon retirement and payment patterns. Actual amounts paid could differfrom this estimate. In addition, non-pension postretirement benefit payments are expected toapproximate $5.1 million in 2008. We have included these expected contributions of $37.2million in the above table. Due to uncertainties regarding significant assumptions involvedin estimating future required contributions to our defined benefit pension and other plans,such as interest rate levels, the amount and timing of asset returns and futurerestructurings, if any, we are not able to reasonably estimate our contributions beyond 2008.In addition, at December 31, 2007, we had $35.7 million of contingent obligations under standbyletters of credit issued in the ordinary course of business to financial institutions, customersand insurance companies to secure short-term support for a variety of commercial transactions,insurance and benefit programs.We had $1,428.8 million of debt outstanding at December 31, 2007 compared with $1,541.7 millionoutstanding at December 31, 2006. Our total debt as a percent of capitalization has decreased from47.8% at December 31, 2006 to 42.2% at December 31, 2007. We believe our future operating cashflows will be sufficient to cover our debt repayments, other contractual obligations, capitalexpenditures and dividends. In addition, we have untapped borrowing capacity that can provide uswith additional financial resources. We currently have a shelf registration statement filed withthe Securities and Exchange Commission (SEC) under which $359.8 million of debt securities,preferred shares or common shares may be issued. In addition, at December 31, 2007, we maintainedcash and short-term investment balances of $502.3 million and had $350.0 million available underour U.S. revolving credit facility and €250.0 million available under our euro revolving creditfacility.GUARANTEESOn May 1, 2006, we sold the FIIS business to SPM Group Holdings, LLC, now known as EmeraldPerformance Materials, LLC (Emerald). As a result of the sale, Emerald became responsible for asupplier contract with SK Corporation (SK). We provided a guarantee to SK, revocable by us upon 60days’ prior written notice, for the timely performance of Emerald’s payment obligations provided SKis unable to collect payment from Emerald using commercially reasonable efforts. On November 5,2007, we terminated the guarantee, which originally extended to January 31, 2008.INDEMNIFICATIONSWe have provided indemnifications to Emerald with respect to the FIIS business sold to them. Theseindemnifications are associated with the price and quantity of raw material purchases, permitcosts, costs incurred due to the inability to obtain permits and environmental matters. For thoseindemnification agreements where a payment by us is probable and estimable, we recorded a liabilityat December 31, 2007. We believe that losses incurred in any of these matters would not have amaterial effect on our business, financial condition or results of operations.**CRITICAL ACCOUNTING POLICIES**The preparation of financial statements and related disclosures in accordance with U.S. generallyaccepted accounting principles (U.S. GAAP) requires us to make judgments, assumptions and estimatesat a specificpoint in time that affect the amounts reported in the accompanying consolidated financialstatements and related notes. In preparing these financial statements, we have utilized availableinformation including our past history, industry standards and the current economic environment,among other factors, in forming our estimates and judgments of certain amounts included in theconsolidated financial statements, giving due consideration to materiality. It is possible thatthe ultimate outcome as anticipated by management in formulating our estimates inherent in thesefinancial statements may not materialize. Application of the critical accounting policiesdescribed below involves the exercise of judgment and the use of assumptions
 

 
as to futureuncertainties and, as a result, actual results could differ from these estimates. In addition,other companies may utilize different estimates, which may impact the comparability of our resultsof operations to similar businesses.ACCOUNTING FOR RESERVES AND CONTINGENCIESOur accounting policies for reserves and contingencies cover a wide variety of business activities,including reserves for potentially uncollectible receivables, slow-moving or obsolete inventory andlegal and environmental exposures. We accrue these reserves when our assessments indicate that itis probable that we have incurred a liability or will not recover an asset and we can reasonablyestimate an amount. For tax exposures, we only recognize the economic benefit associated with atax position if it is more likely than not that we will ultimately sustain a tax position. Afterthis threshold is met, we report a tax position at the largest amount of benefit that is morelikely than not to be ultimately sustained. We review these estimates quarterly based on currentlyavailable information. Actual results may differ from our estimates and our estimates may berevised depending upon the outcome or changed expectations based on the facts surrounding eachexposure. We discuss annually with the audit committee of our board of directors our reserves andcontingencies, as well as our policies and processes for evaluating them.ACCOUNTING FOR SALES DISCOUNTS AND REBATESWe offer sales discounts and rebates to certain customers to promote customer loyalty and toencourage greater product sales. These rebate programs provide that upon the attainment ofpre-established volumes or the attainment of revenue milestones for a specified period, thecustomer receives credits against purchases. We estimate the provision for rebates based upon thespecific terms in each agreement at the time of shipment and an estimate of the customer’sachievement of the respective revenue milestones. We accrue customer claims, returns andallowances and discounts based upon our history of claims and sales returns and allowances. Theestimated provisions significantly could be affected if future occurrences and claims differ fromthese assumptions and historical trends.DETERMINATION OF NET PERIODIC PENSION COSTEach year we review with our actuaries the actuarial assumptions used in the determination of netperiodic pension cost, as prescribed by SFAS No. 87, “Employers Accounting for Pensions.” Thedetermination of net periodic pension cost is based upon a number of actuarial assumptions. Thetwo most critical assumptions are the expected return on plan assets and the discount rate fordetermining the funded status. Other assumptions include the rate of compensation increase anddemographic factors such as retirement age, mortality and turnover. We review the criticalassumptions for our U.S. pension plans with the audit committee of our board of directors. Our netperiodic pension cost for our U.S. pension plans was $24.0 million in 2007, $31.0 million in 2006and $25.7 million in 2005. Our net periodic pension cost for all pension plans was $44.8 millionin 2007, $52.9 million in 2006 and $43.5 million in 2005. The net periodic pension cost for allplans included a settlement loss of $2.9 million and $0.3 million in 2006 and 2005, respectively.In accordance with U.S. GAAP, actual results that differ from the assumptions are accumulated andamortized over future periods and, therefore, affect expense recognized and obligations recorded infuture periods.In developing our assumption for the expected long-term rate of return on plan assets, weconsidered historical returns and the future expectations for returns for each asset class, as wellas the target asset allocation of the pension portfolio. At December 31, 2007, ourweighted-average assumptions for the U.S. pension plans and non-U.S. pension plans was 8.25% and6.63% (7.56% on a weighted-average basis forall plans), respectively, based on our investment mix and projected market conditions. We believeour expected long-term rates of return represent a reasonable return that could be achieved overthe long term using our current asset allocation. At December 31, 2007, our U.S. pension plans’assets had an investment mix that approximated 68% in equity securities and 32% in debt securities,while our non-U.S. pension plans’ assets had an investment mix that approximated 62% in equitysecurities and 38% in debt securities.
 

 
A change in the rate of return of 100 basis points would have the following effects on 2008 netperiodic pension cost:                      100 Basis Point*(In Millions of Dollars)*    Increase    Decrease U.S. pension plans     $ (2.9)     $ 2.9 International pension plans      (2.2)      2.2                All pension plans     $(5.1)     $5.1                The selection of a discount rate for pension plans is required to determine the value of futurepension obligations and represents our best estimate of our cost in the marketplace to settle allpension obligations through annuity purchases. We determined the discount rate based upon currentmarket indicators, including yields from dedicated bond portfolios that provide for a generalmatching of bond maturities with the projected benefit cash flows from our plans. The dedicatedbond portfolios consist of non-callable corporate bonds that are at least AA- quality. We set theDecember 31, 2007 discount rate assumption for our U.S. pension plans at 6.67%, which was anincrease from 6.25% at December 31, 2006. We set the December 31, 2007 weighted-average discountrate assumption for our non-U.S. pension plans at 5.61%, which was an increase from 4.89% atDecember 31, 2006. On a worldwide basis, the weighted-average discount rate increased to 6.19% atDecember 31, 2007 from 5.63% at December 31, 2006.A change in the discount rate of 100 basis points would have the following effects on 2008 netperiodic pension cost:                      100 Basis Point*(In Millions of Dollars)*    Increase    Decrease U.S. pension plans     $ (2.5)     $ 5.3 International pension plans      (5.9)      5.1                All pension plans     $(8.4)     $10.4                At December 31, 2007, the accumulated benefit obligation for all pension plans worldwide exceededthe value of plan assets by $34.8 million. This represents a $48.5 million improvement in fundedstatus from the $83.3 million in the total unfunded accumulated benefit obligation reported in2006. The accumulated benefit obligation exceeded the plan assets for the U.S. pension plans by$12.9 million and the non-U.S. plans by $21.9 million in 2007. The primary driver behind the $48.5million decrease in the unfunded benefit obligations was a result of an increase in discount ratesat December 31, 2007.We expect changes in pension plan assumptions to decrease pension expense for most pension plansworldwide in 2008. We expect the 2008 pension expense to be approximately $40.5 million, excludingthe impact of any settlement charges. The expected decrease in pension expense in 2008, excludingthe impact of settlement charges, primarily is due to an increase in expected returns on assets dueto the increase in fair value of plan assets at December 31, 2007, a reduction in the amortizationof actuarial losses and the increase in the discount rate for all plans, offset by an increase ininterest cost associated with an increase in the projected benefit obligation.DETERMINATION OF POSTRETIREMENT BENEFIT COSTAnnually, we review with our actuaries the key economic assumptions used in calculatingpostretirement benefit cost as prescribed by SFAS No. 106, “Employers’ Accounting forPostretirement Benefits Other than Pensions.” Postretirement benefits include health care and lifeinsurance plans. The determination of postretirement benefit cost is based upon a number ofactuarial assumptions, including the discount rate for determining the accumulated postretirementbenefit obligation, the assumed health care cost trend rates and the ultimate health care trendrate. Except for the U.S. plans, the same discount rate selected for the pension plans generallyis used to calculate the postretirement benefit obligation by country. Net non-
 

 
pension postretirement benefit cost (credit) was $2.6 million in 2007, ($0.1) million in 2006 and$3.4 million in 2005.A change in the discount rate of 100 basis points would have the following effects on 2008postretirement benefit cost:                      100 Basis Point*(In Millions of Dollars)*    Increase    Decrease U.S. postretirement plans     $ (0.4)     $ 0.4 International postretirement plans      (0.2)      0.5                All postretirement plans     $(0.6)     $0.9                A change in the assumed health care cost trend rate of 100 basis points would have the followingeffects on 2008 postretirement benefit cost:                      100 Basis Point*(In Millions of Dollars)*    Increase    Decrease U.S. postretirement plans     $ 1.1      $ (1.0)International postretirement plans      0.7       (0.4)               All postretirement plans     $1.8      $(1.4)               ACCOUNTING FOR BUSINESS COMBINATIONSWe allocate the purchase price of business combinations to assets acquired and liabilities assumedbased on their relative fair value at the date of acquisition pursuant to the provisions of SFASNo. 141, “Business Combinations.” In estimating the fair value of the tangible and intangibleassets and liabilities acquired, we consider information obtained during our due diligence processand utilize various valuation methods including market prices, where available, appraisals,comparisons to transactions for similar assets and liabilities and present value of estimatedfuture cash flows. We are required to make subjective estimates in connection with thesevaluations and allocations.ACCOUNTING FOR IMPAIRMENT OF LONG-LIVED ASSETSWe review the carrying value of our long-lived assets, including property and equipment, wheneverevents or changes in circumstances indicate that the carrying value of the assets may not berecoverable. An impairment loss exists when estimated undiscounted future cash flows expected toresult from the use of the asset, including disposition, are less than the carrying value of theasset. The measurement of the impairment loss to be recognized is based on the difference betweenthe fair value and the carrying amounts of the assets. Fair value generally is determined basedupon a discounted cash flow analysis. In order to determine if an asset has been impaired, assetsare grouped and tested at the lowest level for which identifiable, independent, cash flows areavailable.The determination of both undiscounted and discounted cash flows requires us to make significantestimates and considers the expected course of action at the balance sheet date. Subsequentchanges in estimated undiscounted and discounted cash flows arising from changes in anticipatedactions could impact the determination of whether an impairment exists, the amount of theimpairment charge recorded and whether the effects could materially impact our consolidatedfinancial statements.DISCONTINUED OPERATIONS In accordance with the requirements of SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” we report in discontinued operations the results of a component of our businessthat either has been disposed of or is classified as held for sale. We classify a component of ourbusiness as held for sale if it meets the following criteria as of each balance sheet date:
 

 
 **•** We commit to a plan to sell the disposal group.  **•** The disposal group is available for immediate sale in its present condition, subjectonly to the terms that are usual and customary for sales of such disposal groups.  **•** We have initiated an active program to locate a buyer and other actions required tocomplete the plan to sell.  **•** We believe the sale of the disposal group is probable and expect the transfer toqualify for recognition as a completed sale within one year.  **•** We actively market the disposal group for sale at a price that is reasonable inrelation to its current fair value.  **•** Actions necessary to complete the plan indicate that it is unlikely that significantchanges to the plan will be made or that the plan will be withdrawn.The results of operations of all entities that have been disposed of or are classified as held forsale have been classified in the income (loss) from discontinuedoperations - net of tax line itemin the consolidated statements of income for 2006 and 2005. The 2007, 2006 and 2005 cash flowstatements are presented on a consolidated basis, including both continuing operations anddiscontinued operations for 2006 and 2005.ACCOUNTING FOR IMPAIRMENT OF GOODWILL AND INTANGIBLE ASSETSGoodwill represents the excess of purchase price and related costs over the value assigned to thenet tangible and identifiable intangible assets of businesses acquired. In accordance with SFASNo. 142, “Goodwill and Other Intangible Assets,” goodwill is to be tested annually and betweenannual tests if events occur or circumstances change that would more likely than not reduce thefair value of an operating segment below its carrying amount. We have elected October 1 as theannual evaluation date to test for potential goodwill impairment. The annual goodwill impairmenttest requires us to make a number of assumptions and estimates concerning future levels of earningsand cash flow, which are based upon our strategic plans. The combination of a discounted cash flowanalysis and terminal value model is used to determine the fair value of each reporting unit.While we use available information to prepare estimates and to perform the impairment evaluation,actual results could differ significantly resulting in future impairment and charges related torecorded goodwill balances. We identified no impairment of goodwill in the annual impairment testcompleted in 2007. (See Note 6 to the consolidated financial statements.)Intangible assets resulting from business acquisitions, including customer lists, purchasedtechnology, trademarks, patents, land-use rights and non-compete agreements, are amortized on astraight-line method over periods ranging from 3 to 40 years. Under SFAS No. 142, intangibleassets determined to have indefinite lives are not amortized, but are tested for impairment atleast annually. We have elected October 1 as the annual evaluation date to test for potentialimpairment of indefinite lived intangible assets. The combination of a discounted cash flowanalysis and terminal value model is used to determine whether the fair value of an intangibleasset exceeds its carrying amount. As part of the annual impairment test, the non-amortizedintangible assets are reviewed to determine if the indefinite status remains appropriate.We completed a corporate identity review in the fourth quarter of 2006 and made a finaldetermination in January 2007 to no longer use the trade name “Noveon” to describe the LubrizolAdvanced Materials segment of our company and that its use would be discontinued except inconnection with the consumer specialties product line. As a result, we recognized an impairmentcharge for the Noveon trade name in accordance with SFAS No. 142. We calculated a pretax charge of$41.2 million ($25.4 million after tax) to reduce the related asset to its estimated fair value.We reflected this charge in the fourth quarter of 2006 as we believed at that time we would morelikely than not discontinue the use of the Noveon trade name, except in the limited context of theconsumer specialties product line.
 

 
ASSET-RETIREMENT OBLIGATIONSWe account for asset retirement obligations in accordance with SFAS No. 143, “Accounting for AssetRetirement Obligations” and Financial Accounting Standards Board (FASB) Interpretation (FIN) No.47, “Accounting for Conditional Asset-Retirement Obligations - an interpretation of FASB StatementNo. 143.” FIN No. 47 requires the recognition of a liability for the fair value of a legalobligation to perform asset-retirement obligations (AROs) that are conditional on a future event ifthe amount can be reasonably estimated. We have identified AROs related to certain of our leasedfacilities and to asbestos remediation activities that may be required at other company-ownedfacilities in the future. We record liabilities for AROs at the time that they are identified andwhen they can be reasonably estimated. Due to the long-term, productive nature of some of ourmanufacturing operations, absent plans or expectation of plans to initiate asset retirementactivities, we are unable to reasonably estimate the fair value of such asbestos remediationliabilities since the potential settlement dates cannot be determined at this time.NEW ACCOUNTING STANDARDS**SFAS No. 141R**In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations.” Thisstatement replaces SFAS No. 141, “Business Combinations,” requires an acquirer to recognize theassets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at theacquisition date, measured at their fair values as of that date, with limited exceptions. SFAS No.141R requires costs incurred to effect the acquisition to be recognized separately from theacquisition as period costs. SFAS No. 141R also requires the acquirer to recognize restructuringcosts that the acquirer expects to incur, but is not obligated to incur, separately from thebusiness combination. In addition, this statement requires an acquirer to recognize assets andliabilities assumed arising from contractual contingencies as of the acquisition date, measured attheir acquisition-date fair values. Other key provisions of this statement include the requirementto recognize the acquisition-date fair values of research and development assets separately fromgoodwill and the requirement to recognize changes in the amount of deferred tax benefits that arerecognizable due to the business combination in either income from continuing operations in theperiod of the combination or directly in contributed capital, depending on the circumstances. AtDecember 31, 2007, we had amounts recorded in our financial statements for unrecognized taxbenefits and valuation allowances related to past acquisitions. Any reversal of these amountsprior to the adoption of SFAS No. 141R would affect goodwill. However, subsequent to the adoptionof SFAS No. 141R, any reversals would affect the income tax provision in the period of reversal.With the exception of certain tax-related aspects described above, this statement appliesprospectively to business combinations for which the acquisition date is on or after the beginningof the first annual reporting period after December 15, 2008. We currently are evaluating theimpact of this recently issued standard on our consolidated financial statements.**SFAS No. 160**In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Financial Statements-an amendment of ARB No. 51.” This statement amends Accounting Research Bulletin No. 51,“Consolidated Financial Statements,” to establish accounting and reporting standards fornoncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. It clarifiesthat a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entitythat should be reported as equity in the consolidated financial statements. This statementrequires consolidated net income attributable to both the parent and the noncontrolling interest tobe reported and disclosed in the consolidated financial statements. This statement also requiresexpanded disclosures in the consolidated financial statements that clearly identify and distinguishbetween the interests of the parent’s owners and the interests of the noncontrolling owners of asubsidiary. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscalyears, beginning after December 15, 2008 and shall be applied prospectively as of the beginning ofthe fiscal year in which it is initially adopted, except for the presentation and disclosurerequirements, which
 

 
are applied retrospectively for all periods presented. Early adoption is prohibited. We currentlyare evaluating the impact of this recently issued standard on our consolidated financialstatements.**SFAS No. 159**In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities.” This statement permits entities to make an irrevocable election to measuremany financial instruments and certain other items at fair value at specified election dates. Thefair value option may be applied instrument by instrument and, if applied, then it must be appliedto the entire instrument. Unrealized gains and losses on items for which the entity elects thefair value option are reported in earnings. SFAS No. 159 is effective for fiscal years beginningafter November 15, 2007. Early adoption is permitted as of the beginning of the fiscal year thatbegins on or before November 15, 2007, provided the entity also elects to apply the provisions ofSFAS No. 157, “Fair Value Measurements.” Entities are not permitted to apply this statementretrospectively to the fiscal years preceding the effective date unless the entity chooses earlyadoption. We currently are evaluating the impact of this recently issued standard on ourconsolidated financial statements.**SFAS No. 158**In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106, and 132R.” Thisstatement requires an employer to recognize a plan’s funded status in its statement of financialposition, measure a plan’s assets and obligations as of the end of the employer’s fiscal year andrecognize the changes in a plan’s funded status in comprehensive income in the year in which thechanges occur. SFAS No. 158’s requirement to recognize a plan’s funded status and new disclosurerequirements are effective for us as of December 31, 2006. The requirement to measure plan assetsand benefit obligations as of the date of our fiscal year-end statement of financial position iseffective for fiscal years ending after December 15, 2008. Currently, we measure plan assets andbenefit obligations as of the date of our fiscal year end. We adopted the required provisions ofSFAS No. 158 on December 31, 2006.**SFAS No. 157**In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement definesfair value, establishes a framework for measuring fair value in accordance with U.S. GAAP andexpands disclosure about fair value measurements. SFAS No. 157 does not expand the use of fairvalue measures in financial statements, but simplifies and codifies related guidance within U.S.GAAP. SFAS No. 157 establishes a fair value hierarchy using observable market data as the highestlevel and an entity’s own fair value assumptions as the lowest level. SFAS No. 157 is effectivefor fiscal years beginning after November 15, 2007 and interim periods within those years. SFASNo. 157 requires adoption prospectively as of the beginning of the fiscal year in which thisstatement is initially applied, with the exception of certain financial instruments in whichadoption is applied retrospectively as of the beginning of the fiscal year in which this statementinitially is applied. We currently are evaluating the impact of this recently issued standard onour consolidated financial statements.**FIN No. 48**In July 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes,” thatprescribes a recognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken in a tax return. UnderFIN No. 48, a contingent tax asset only will be recognized if it is more likely than not that a taxposition ultimately will be sustained. After this threshold is met, a tax position is reported atthe largest amount of benefit that is more likely than not to be realized. FIN No. 48 alsoprovides guidance on derecognition, classification, interest and penalties, accounting in interimperiods and disclosure. FIN No. 48 was effective for fiscal years beginning after December 15,2006. FIN No. 48 requires the cumulative effect of applying the provisions to be reportedseparately as an adjustment to the opening balance of retained earnings in the year of adoption.Effective January 1, 2007, we adopted the provisions of FIN No. 48.
 

 
As a result of adopting FIN No. 48 on January 1, 2007, we recognized an $8.9 million reduction toretained earnings and a $5.4 million increase to goodwill for pre-acquisition income taxliabilities of Noveon International. At January 1, 2007, after recording this FIN No. 48 adoptionimpact, we had gross unrecognized tax benefits of $57.8 million, of which $38.8 million, ifrecognized, would have affected the effective tax rate. At December 31, 2007, we had grossunrecognized tax benefits of $59.3 million, of which $39.3 million, if recognized, would haveaffected the effective tax rate.We recognize accrued interest and penalties related to unrecognized tax benefits as a component ofthe income tax provision. During the year ended December 31, 2007, we recognized gross interestexpense of $4.2 million and gross interest income of $3.2 million in our consolidated statements ofincome. At December 31, 2007 and 2006, we had accrued $7.7 million and $7.1 million, respectively,for the potential payment of interest and penalties.We operate in numerous taxing jurisdictions and are subject to regular examinations by various U.S.federal, state and foreign jurisdictions. Our income tax positions are based on research andinterpretations of the income tax laws and rulings in each of the jurisdictions in which we dobusiness. Due to the subjectivity of interpretations of laws and rulings in each jurisdiction, thedifferences and interplay in tax laws between those jurisdictions and difficulty in estimating thefinal resolution of complex tax audit matters, our estimates of income tax liabilities may differfrom actual payments or assessments.We do not anticipate that the total unrecognized tax benefits will change significantly due to thesettlement of audits and the expiration of statute of limitations within one year of December 31,2007.With few exceptions, we no longer are subject to U.S. federal, state and local tax examinations foryears before 2001 and foreign jurisdiction examinations for years before 2000.Effective with the adoption of FIN No. 48, the majority of our unrecognized tax benefits areclassified as noncurrent liabilities because payment of cash is not expected within one year.Prior to the adoption of FIN No. 48, we classified unrecognized tax benefits in accrued expensesand other current liabilities.**SFAS No. 123R**In December 2004, the FASB issued SFAS No. 123R. This standard requires compensation costs relatedto share-based payment transactions to be recognized in the financial statements. With limitedexceptions, the amount of compensation cost is measured based on the grant-date fair value of theequity or liability instruments issued. In addition, liability awards are remeasured eachreporting period. Compensation cost is recognized over the period that an employee providesservice in exchange for the award. This standard replaces SFAS No. 123, “Accounting forStock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees,” and applies to all awards granted, modified, repurchased or cancelled after July 1,2005. In April 2005, the SEC amended the compliance date of SFAS No. 123R through an amendment ofRegulation S-X. We adopted SFAS No. 123R on January 1, 2006. Our adoption of SFAS No. 123Rincrementally increased before-tax compensation expense by approximately $2.4 million during 2006.**CAUTIONARY STATEMENTS FOR SAFE HARBOR PURPOSES**This Management’s Discussion and Analysis of Financial Condition and Results of Operations containsforward-looking statements within the meaning of the federal securities laws. As a general matter,forward-looking statements are those focused upon future plans, objectives or performance asopposed to historical items and include statements of anticipated events or trends and expectationsand beliefs relating to matters not historical in nature. Forward-looking statements are subjectto uncertainties and factors relating to our operations and business environment, all of which aredifficult to predict and many of which are beyond our control. These uncertainties and factorscould cause our actual results to differ materially from those matters expressed in or implied byany forward-looking statements, although we believe our expectations reflected in thoseforward-looking statements are based upon reasonable assumptions. For
 

 
this purpose, any statements contained herein that are not statements of historical fact should bedeemed to be forward-looking statements.We believe that the following factors, among others, could affect our future performance and causeour actual results to differ materially from those expressed or implied by forward-lookingstatements made in this annual report: **•** The cost, availability and quality of raw materials, especially petroleum-based products.  **•** Our ability to sustain profitability of our products in a competitive environment.  **•** The demand for our products as influenced by factors such as the global economic environment,longer-term technology developments and the success of our commercial development programs.  **•** The risks of conducting business in foreign countries, including the effects of fluctuationsin currency exchange rates upon our consolidated results and political, social, economic andregulatory factors.  **•** The extent to which we are successful in expanding our business in new and existing marketsand in identifying, understanding and managing the risks inherent in those markets.  **•** The effects of required principal and interest payments and the high degree of volatility inthe capital markets on our ability to fund capital expenditures and acquisitions and to meetoperating needs.  **•** Our ability to identify, complete and integrate acquisitions for profitable growth andoperating efficiencies.  **•** Our success at continuing to develop proprietary technology to meet or exceed new industryperformance standards and individual customer expectations.  **•** Our ability to implement a new common information systems platform primarily into ourLubrizol Advanced Materials segment successfully, including the management of project costs,its timely completion and realization of its benefits.  **•** Our ability to continue to reduce complexities and conversion costs and modify our coststructure to maintain and enhance our competitiveness.  **•** Our success in retaining and growing the business that we have with our largest customers.  **•** The cost and availability of energy, especially natural gas and electricity.  **•** The effect of interest rate fluctuations on our net interest expense.  **•** The risk of weather-related disruptions to our Lubrizol Additives production facilitieslocated near the U.S. Gulf Coast.  **•** Significant changes in government regulations affecting environmental compliance.**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**We operate manufacturing and blending facilities, laboratories and offices around the world andutilize fixed-rate and variable-rate debt to finance our global operations. As a result, we aresubject to business risks inherent in non-U.S. activities, including political and economicuncertainties, import and export limitations, and market risks related to changes in interest ratesand foreign currency exchange rates. We believe the political and economic risks related to ourforeign operations are mitigated due to the stability of the countries in which our largest foreignoperations are located.
 

 
In the normal course of business, we use derivative financial instruments including interest rateand commodity hedges and forward foreign currency exchange contracts to manage our market risks.Our objective in managing our exposure to changes in interest rates is to limit the impact of suchchanges on our earnings and cash flow. Our objective in managing the exposure to changes inforeign currency exchange rates is to reduce volatility on our earnings and cash flow associatedwith such changes. Our principal currency exposures are the euro, the pound sterling, the Japaneseyen and certain Latin American currencies. Our objective in managing our exposure to changes incommodity prices is to reduce the volatility on earnings of utility expense. We do not holdderivatives for trading purposes.We measure our market risk related to our holdings of financial instruments based on changes ininterest rates, foreign currency rates and commodity prices utilizing a sensitivity analysis. Thesensitivity analysis measures the potential loss in fair value, cash flow and earnings based on ahypothetical 10% change (increase and decrease) in interest, currency exchange rates and commodityprices. We use current market rates on our debt and derivative portfolios to perform thesensitivity analysis. Certain items such as lease contracts, insurance contracts and obligationsfor pension and other postretirement benefits are not included in the analysis.Our primary interest rate exposures relate to our cash and short-term investments, fixed-rate andvariable-rate debt and interest rate swaps. The calculation of potential loss in fair value isbased on an immediate change in the net present values of our interest rate-sensitive exposuresresulting from a 10% change in interest rates. The potential loss in cash flow and income beforetax is based on the change in the net interest income/expense over a one-year period due to animmediate 10% change in rates. A hypothetical 10% increase in interest rates would have had afavorable impact and a hypothetical 10% decrease in interest rates would have had an unfavorableimpact on fair values of $49.8 million and $41.1 million at December 31, 2007 and 2006,respectively. In addition, a hypothetical 10% increase in interest rates would have had anunfavorable impact and a hypothetical 10% decrease in interest rates would have had a favorableimpact on cash flows and income before tax of $0.8 million and $1.6 million in 2007 and 2006,respectively.Our primary currency exchange rate exposures are to foreign currency-denominated debt, intercompanydebt, cash and short-term investments and forward foreign currency exchange contracts. Thecalculation of potential loss in fair value is based on an immediate change in the U.S. dollarequivalent balances of our currency exposures due to a 10% shift in exchange rates. The potentialloss in cash flow and income before tax is based on the change in cash flow and income before taxover a one-year period resulting from an immediate 10% change in currency exchange rates. Ahypothetical 10% increase in currency exchange rates would have had an unfavorable impact and ahypothetical 10% decrease in currency exchange rates would have had a favorable impact on fairvalues of $17.0 million and $3.5 million at December 31, 2007 and 2006, respectively. In addition,a hypothetical 10% increase in currency exchange rates would have had an unfavorable impact and ahypothetical 10% decrease in currency exchange rates would have had a favorable impact on cashflows of $24.9 million and $21.1 million and on income before tax of $6.5 million and $4.0 millionin 2007 and 2006, respectively.Our primary commodity hedge exposures relate to natural gas and electric utility expenses. Thecalculation of potential loss in fair value is based on an immediate change in the U.S. dollarequivalent balances of our commodity exposures due to a 10% shift in the underlying commodityprices. The potential loss in cash flow and income before tax is based on the change in cash flowand income before tax over a one-year period resulting from an immediate 10% change in commodityprices. A hypothetical 10% increase in commodity prices would have had a favorable impact and ahypothetical 10% decrease in commodity prices would have had an unfavorable impact on fair values,cash flows and income before tax of $1.4 million and $1.3 million in 2007 and 2006, respectively.
 

 
**MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**The management of The Lubrizol Corporation and its subsidiaries (the Company) is responsible forestablishing and maintaining adequate internal control over financial reporting. The LubrizolCorporation’s internal control system was designed to provide reasonable assurance to the Company’smanagement and board of directors regarding the preparation and fair presentation of publishedfinancial statements.All internal control systems, no matter how well designed, have inherent limitations. Therefore,even those systems determined to be effective can provide only reasonable assurance with respect tofinancial statement preparation and presentation.The Lubrizol Corporation’s management assessed the effectiveness of the Company’s internal controlover financial reporting as of December 31, 2007. In making this assessment, management used thecriteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)in *Internal Control-Integrated Framework.*Based on this assessment, management believes that, asof December 31, 2007, the Company’s internal control over financial reporting is effective based onthose criteria.Theeffectiveness of the Company’s internal control over financialreporting as of December 31, 2007 has been audited by Deloitte &Touche LLP, an independent registered public accounting firm, whoexpressed an unqualified opinion as stated in their report, a copyof which is included in this annual report./s/ JamesL. Hambrick