Avon 2005 Annual Report Download - page 33

2005฀ANNUAL฀REPORT฀฀53
Realized gains and losses on a derivative are reported on the
Consolidated Statements of Cash Flows consistent with the
underlying hedged item.
We assess, both at the hedge’s inception and on an ongoing basis,
whether the derivatives that are used in hedging transactions are
highly effective in offsetting changes in fair values or cash flows of
hedged items. Highly effective means that cumulative changes in
the fair value of the derivative are between 80% – 125% of the
cumulative changes in the fair value of the hedged item. The inef-
fective portion of the derivative’s gain or loss, if any, is recorded
in earnings in other expense, net on the Consolidated Statements
of Income. We include the change in the time value of options in
our assessment of hedge effectiveness. When we determine that
a derivative is not highly effective as a hedge, hedge accounting
is discontinued. When it is probable that a forecasted transaction
will not occur, we discontinue hedge accounting for the affected
portion of the forecasted transaction, and reclassify gains and
losses that were accumulated in OCI to earnings in other expense,
net on the Consolidated Statements of Income.
Interest Rate Risk
Our long-term, fixed-rate borrowings are subject to interest rate
risk. We use interest rate swaps, which effectively convert the
fixed rate on the debt to a floating interest rate, to manage our
interest rate exposure. At December 31, 2005 and 2004, we held
interest rate swap agreements that effectively converted approxi-
mately 60% and 75%, respectively, of our outstanding long-term,
fixed-rate borrowings to a variable interest rate based on LIBOR.
Our total exposure to floating interest rates at December 31, 2005
and 2004 was approximately 80%.
At December 31, 2005 and 2004, we had interest rate swaps
designated as fair value hedges of fixed-rate debt pursuant to FAS
No. 133, “Accounting for Derivative Instruments and Hedging
Activities”, with unrealized (losses) gains of ($14.5) and $11.6,
respectively. Additionally, at December 31, 2005 and 2004, we
had interest rate swaps that are not designated as fair value
hedges with fair values of $18.1 and $10.9, respectively.
Long-term debt at December 31, 2005 and 2004 includes net
unrealized (losses) gains of ($15.3) and $6.9, respectively, on
interest rate swaps designated as fair value hedges. Long-term
debt also includes remaining unamortized gains of $17.2 and
$10.3 at December 31, 2005 and 2004, resulting from terminated
swap agreements and swap agreements no longer designated as
fair value hedges, which are being amortized to interest expense
over the remaining terms of the underlying debt. There was no
hedge ineffectiveness for the years ended December 31, 2005,
2004 or 2003, related to these interest rate swaps.
During 2005, we entered into treasury lock agreements that we
designated as cash flow hedges and were used to hedge exposure
to a possible rise in interest rates prior to the anticipated issuance
of 10- and 30-year bonds. In December 2005, we decided that a
more appropriate strategy was to issue five-year bonds given our
strong cash flow and high level of cash and cash equivalents.
As a result of the change in strategy, in December 2005, we
de-designated the locks as hedges and reclassified the gain of
$2.5 on the locks from accumulated comprehensive income to
other expense, net. Upon the change in strategy in December
2005, we entered into a treasury lock agreement with a notional
amount of $250.0 designated as a cash flow hedge of the antici-
pated issuance of five-year bonds (see Note 19, Subsequent Events).
Foreign Currency Risk
We use foreign currency forward contracts and options to hedge
portions of our forecasted foreign currency cash flows result-
ing from intercompany royalties, intercompany loans, and other
third-party and intercompany foreign currency transactions
where there is a high probability that anticipated exposures will
materialize. These contracts have been designated as cash flow
hedges. The primary currencies for which we have net underlying
foreign currency exchange rate exposures are the Argentine peso,
Brazilian real, British pound, Chinese renminbi, the Euro, Japanese
yen, Mexican peso, Polish zloty, Russian ruble, Turkish lira and
Venezuelan bolivar.
For the years ended December 31, 2005, 2004 and 2003, the
ineffective portion of our cash flow foreign currency derivative
instruments and the net gains or losses reclassified from OCI
to earnings for cash flow hedges that had been discontinued
because the forecasted transactions were not probable of occur-
ring were not material.
At December 31, 2005, the maximum remaining term over which
we were hedging foreign exchange exposures to the variability
of cash flows for all forecasted transactions was 14 months. As
of December 31, 2005, we expect to reclassify $1.7 ($1.3, net
of taxes) of net losses on derivative instruments designated as
cash flow hedges from accumulated other comprehensive loss to
earnings during the next 12 months due to (a) foreign currency
denominated intercompany royalties, (b) intercompany loan settle-
ments and (c) foreign currency denominated purchases or receipts.