Mattel (MAT)

Stock Option Review

During 2006, Mattel recognized non-cash compensation expense of $19.3 million ($13.3 million net of income tax) related to prior period unintentional stock option accounting errors associated with the use of incorrect measurement dates for certain grants. The correcting adjustment also had the effect of increasing noncurrent deferred tax assets by $3.5 million and additional paid in capital by $16.8 million as of December 31, 2006.

Stock Option Review

During 2006, Mattel recognized non-cash compensation expense of $19.3 million ($13.3 million net of income tax) related to prior period unintentional stock option accounting errors associated with the use of incorrect measurement dates for certain grants. The correcting adjustment also had the effect of increasing noncurrent deferred tax assets by $3.5 million and additional paid in capital by $16.8 million as of December 31, 2006.

Stock Option Review

Stock Option Review

In August 2006, two derivative shareholder lawsuits were filed against Mattel and certain of its past and present executive officers and members of its Board of Directors in Los Angeles County Superior Court, alleging that certain stock option grants had been backdated (the “State Court Derivative Shareholder Lawsuits”). During the third quarter of 2006, Mattel commenced and completed a comprehensive review of its historical stock option practices for grants made during the period from the fourth quarter of 1993 through the third quarter of 2006. Outside legal counsel participated in this review, including performing certain investigative procedures.

The review found that there had been no backdating of stock option grants, no misconduct or manipulation associated with stock option grant dates, no intentional deviations from generally accepted accounting principles, and no material inaccuracies with respect to the current or historical financial statements of Mattel. The review did identify some administrative procedural deficiencies that resulted in unintentional accounting errors, principally relating to situations in which, as of the grant date approved by the Compensation Committee, an aggregate number of options to be granted was approved and the exercise price for the options was established, but the allocation of those options to certain individual employee recipients was not yet finalized (thus resulting

86

Table of Contents

in later measurement dates for accounting purposes for those individual grants). These accounting errors related to grants made to the general population of employees. The review found no such errors associated with any executive officer or Board member grants and no errors associated with any grants made after 2002.

The unintentional accounting errors associated with the use of incorrect measurement dates for certain grants caused non-cash compensation expense to be understated by a cumulative amount of $19.3 million ($13.3 million net of income tax) over the years 1995 through 2005. All of the errors were related to grants made prior to 2003, and the impact on income from continuing operations was not material to any previously reported period (less than 1% in every year). Because the errors are not material to any prior period financial statement and the impact on the current year of correcting the cumulative errors is also not material, a correcting entry to record the cumulative impact of these errors was recorded in the third quarter of 2006. The entry increased other selling and administrative expenses by $19.3 million and reduced provision for income taxes by $6.0 million, which resulted in a $13.3 million reduction in net income. The correcting adjustment also had the effect of increasing noncurrent deferred tax assets by $3.5 million and additional paid-in capital by $16.8 million as of December 31, 2006.

In January 2007, two additional shareholder derivative lawsuits were filed against Mattel and certain of its past and present executive officers and members of its Board of Directors in United States District Court for the Central District of California, alleging that certain stock options grants had been backdated (the “Federal Court Derivative Shareholder Lawsuits”). The factual allegations in the Federal Court Derivative Shareholder Lawsuits are identical to those in the State Court Derivative Shareholder Lawsuits.

In light of the results of the review of its historical stock option practices, Mattel does not believe that final resolution of the State Court Derivative Shareholder Lawsuits or the Federal Court Derivative Shareholder Lawsuits will have a material adverse impact on its consolidated results of operations or financial position.

Stock Option Review

In August 2006, two derivative shareholder lawsuits were filed against Mattel and certain of its past and present executive officers and members of its Board of Directors in Los Angeles County Superior Court, alleging that certain stock option grants had been backdated (“the Derivative Shareholder Lawsuits”). During the third quarter of 2006, Mattel commenced and completed a comprehensive review of its historical stock option practices for grants made during the period from the fourth quarter of 1993 through the third quarter of 2006. Outside legal counsel participated in this review, including performing certain investigative procedures.

The review found that there had been no backdating of stock option grants, no misconduct or manipulation associated with stock option grant dates, no intentional deviations from generally accepted accounting principles, and no material inaccuracies with respect to the current or historical financial statements of Mattel. The review did identify some administrative procedural deficiencies that resulted in unintentional accounting errors, principally relating to situations in which, as of the grant date approved by the Compensation Committee, an aggregate number of options to be granted was approved and the exercise price for the options was established, but the allocation of those options to certain individual employee recipients was not yet finalized (thus resulting in later measurement dates for accounting purposes for those individual grants). These accounting errors related to grants made to the general population of employees. The review found no such errors associated with any executive officer or Board member grants and no errors associated with any grants made after 2002.

The unintentional accounting errors associated with the use of incorrect measurement dates for certain grants caused non-cash compensation expense to be understated by a cumulative amount of $19.3 million ($13.3 million net of income tax) over the years 1995 through 2005. All of the errors were related to grants made prior to 2003, and the impact on income from continuing operations was not material to any previously reported period (less than 1% in every year). Because the errors are not material to any prior period financial statement and the impact on the current year of correcting the cumulative errors is also not material, a correcting entry to record the cumulative impact of these errors was recorded in the third quarter of 2006. The entry increased other selling and administrative expenses by $19.3 million and reduced provision for income taxes by $6.0 million, which resulted in a $13.3 million reduction in net income. The correcting adjustment also had the effect of increasing noncurrent deferred tax assets by $3.5 million and additional paid-in capital by $16.8 million as of September 30, 2006.

In light of the results of this review, Mattel does not consider the Derivative Shareholder Lawsuits to be material.

13

Table of Contents

Stock Option Review

During the third quarter of 2006, the Company, along with outside counsel, commenced and completed a comprehensive review of its historical stock option practices for grants made during the period beginning fourth quarter 1993 through third quarter 2006. The review found that there had been no backdating of stock option grants, no misconduct or manipulation associated with stock option grant dates, no intentional deviations from generally accepted accounting principles, and no material inaccuracies with respect to the current or historical financial statements of the Company. The review did identify some administrative procedural deficiencies which resulted in unintentional errors associated with incorrect accounting measurement dates for certain grants made to the general population of employees prior to 2003. The review found no errors associated with any executive officer or Board member grants and no errors associated with any grants made after 2002.

The unintentional accounting errors principally related to situations in which, as of the grant date approved by the Compensation Committee of the Board of Directors, an aggregate number of options to be granted was approved and the exercise price was established, but the allocation of those options to certain individual employee recipients was not yet finalized. The errors associated with the use of incorrect accounting measurement dates caused non-cash compensation expense to be understated by a cumulative amount of $19 million ($13 million net of income tax) over the years 1995 through 2005, the period in which the options in question vested. The impact on income from continuing operations was not material to any previously reported period (less than 1 percent in any individual year). Because the errors are not material, a correcting entry was recorded in the third quarter of 2006 to adjust for their cumulative impact on the Company’s financial statements. The adjustments increased SG&A and reduced operating income by $19 million, or 110 basis points of net sales. This resulted in an after-tax reduction to net income of $13 million, or 70 basis points of net sales. The net impact on third quarter earnings was a reduction of $0.03 per share.