Reference no: EM131119259
Excerpts from the disclosures on derivatives in a recent year (denoted Year 4) by The Coca-Cola Company (Coke) appear below.
Our Company uses derivative financial instruments primarily to reduce our exposure to adverse fluctuations in interest rates and foreign exchange rates, and, to a lesser extent, in commodity prices and other market risks. When entered into, the Company formally designates and documents the financial instrument as a hedge of a specific underlying exposure, as well as the risk management objectives and strategies for undertaking the hedge transaction. The Company formally assesses, both at the inception and at least quarterly thereafter, whether the financial instruments that are used in hedging transactions are effective at offsetting changes in either the fair value or cash flows of the related underlying exposures. Our Company does not enter into derivative financial instruments for trading purposes.
Our Company monitors our mix of fixed rate and variable-rate debt. This monitoring includes a review of business and other financial risks. We also enter into interest rate swap agreements to manage these risks. These contracts had maturities of less than one year on December 31, Year 4. The fair value of our Company's interest rate swap agreements was approximately $6 million at December 31, Year 4. The Company estimates the fair value of its interest rate management derivatives based on quoted market prices. Interest rate swap agreements are accounted for as fair value hedges. During Year 4, there has been no ineffectiveness related to fair value hedges.
We enter into forward exchange contracts to hedge certain portions of forecasted cash flows denominated in foreign currencies. These contracts had maturities up to one year on December 31, Year 4. The purpose of our foreign currency hedging activities is to reduce the risk that our eventual U.S. dollar net cash inflows resulting from sales outside the U.S. will be adversely affected by changes in exchange rates. We designate these derivatives as cash flow hedges. During Year 4, we decreased accumulated other comprehensive income by $76 million ($46 million after tax) for changes in the fair value of cash flow hedges. The amount recorded in earnings for the ineffective portion of cash flow hedges during Year 4 was not significant. We also reclassified net losses of $86 million ($52 million after tax) from accumulated other comprehensive income to earnings. The accumulated net loss on cash flow derivatives on December 31, Year 4 is $56 million ($34 million after tax). The carrying and fair value of foreign exchange contracts on December 31, Year 4 is $39 million.
We monitor our exposure to financial market risks using value-at-risk models. Our value-at-risk calculations use a historical simulation model to estimate potential future losses in the fair value of our derivatives and other financial instruments that could occur as a result of adverse movements in foreign currency and interest rates. We examined historical weekly returns over the previous 10 years to calculate our value at risk. The average value at risk represents the simple average of quarterly amounts over the past year. According to our interest rate value-at-risk calculations, we estimate with 95 percent confidence that an adverse move in interest rates over a one-week period would not have a material impact on our consolidated financial statements for Year 4. Similar calculations for adverse movements in foreign exchange rates indicate a maximum impact on earnings over a one-week period of $17 million. Net income for Year 4 was $4,847 million.
a. Coke indicates that it "formally specifies the risk management objectives and strategies for undertaking the hedge transactions." Identify the risk management objective and describe how the particular derivative accomplishes this objective with respect to interest rate swap agreements.
b. Repeat Part a for forward exchange contracts.
c. What is the rationale for Coke's designation of the interest rate swaps as fair value hedges and the forward exchange contracts as cash flow hedges?
d. Why does Coke assess both initially and at least quarterly the effectiveness of these hedging instruments?
e. Compute the amount that Coke initially recorded on its books for foreign exchange contracts outstanding on December 31, Year 4. What events will cause the carrying value of these contracts at any later date to differ from the amounts initially recorded?
f. For Year 4, Coke reports a $76 million net loss from changes in the value of cash flow hedges. What does the disclosure that Coke recognized
a net loss instead of a net gain suggest about the direction of changes in exchange rates between the U.S. dollar and the foreign currencies underlying the foreign exchange contracts? Will the forward exchange contracts likely appear on Coke's balance sheet as assets or liabilities? Explain.
g. Justify Coke's treatment of the $76 million net loss from changes in the value of cash flow hedges during Year 4 as a decrease in accumulated other comprehensive income instead of an ineffective cash flow hedge that should be included in earnings.
h. The income tax law taxes gains and losses from changes in the fair value of foreign exchange contracts at the time of settlement. Will the tax effects of the $76 million pretax loss for Year 4 affect current taxes payable or deferred taxes? If the answer to the previous question is deferred taxes, will it affect deferred tax assets or deferred tax liabilities? Explain.
i. Describe the likely event that will cause Coke to reclassify amounts from accumulated other comprehensive to earnings.
j. Assess the effectiveness of Coke's management of risk changes from interest and foreign exchange rates for Year 4.