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AC 650 ? International Accounting - McBride
W-9 Chapter 11
Case 11-2 Value at Risk: What Are Our Options?
The scene is a conference room on the 10th floor of an office building on Wall Street, occupied by Anthes
Enterprises, a small, rapidly growing manufacturer of electronic trading systems for equities, commodities, and
The agenda for the 8:00 A.M. meeting concerns reporting issues associated with a potential sales contract for the
stock exchange in the Slovak Republic, which wants to upgrade its technology to effectively participate in the
globalization of financial markets. In attendance are Anthes Enterprise?s COO Shevon Estwick, Controller Sy
Jones, Treasurer, Bebi Karimbaksh, and Vice President of Marketing Autherine Allison.
SHEVON: Thank you for agreeing to meet on such short notice. Autherine, are you ready to give us an update
on Slovakia? AUTHERINE: You mean the Slovak Republic.
SHEVON: Yes. AUTHERINE: I think there is a 90 percent chance we?ll land the con- tract. Things move a little slowly over there
and they?re still concerned about some of the legal details of our sales contract. I think they find the
legalese a bit intimidating and I can?t say I blame them. I?ve scheduled another trip next month to go
over contract details. This time I?m taking our legal counsel and have asked him to prepare another
draft expressed in terms that are easier to understand. They?re also waiting for approvals from their
Central Bank, which has to approve major transactions such as this one.
SHEVON: Good. Are we prepared to deliver on the contract? AUTHERINE: Yes, we?ve lined up the financing; have done our credit checks, and the equipment and installation
teams are ready to proceed on two weeks? notice.
SHEVON: Given the size of the contract, are we hedged against the possibility of a devaluation? BEBI: Yes, we?ve written a put option on the koruna for 90 days. SHEVON: Do we think we?ll close on the deal before then? BEBI: Autherine doesn?t think so, but you never know. The problem is no one will write an option for a
longer term. We?ll renew the option as we have other transactions of this extended duration. SHEVON: Sy, are we all right on the reporting front? SY: Not really. SHEVON: How?s that? SY: It looks like we?re up against a reporting standard that requires that gains or losses on cash flow
hedges whose maturities do not match that of the underlying be recognized in current earnings. SHEVON: Come again? SY: The bottom line is that we won?t be able to treat gains or losses on our put options as a part of
comprehensive income, but we?ll have to recognize them in current earnings. SHEVON: Won?t that mess up our bottom line? SY: I?m afraid so. There would be no offsetting gain or loss from our anticipated sale. BEBI: It?s taken me a whole year to get to know the right people and win their trust and friendship. I now
have that. There?s no doubt in my mind that this sale is a done deal and I anticipate closing the
transaction within the next six to nine months. SY: That may be, but we just can?t find anyone who?s willing to write an option for more than 90 days at a time.
SHEVON: I don?t want to think about what the accounting will do to our stock price! I mean, we?re about to
float our first Euro-equity issue. A lower offering price would be disastrous at this stage of our
development, not to mention the effect on our shareholders. AUTHERINE: Given the nature of our business, I don?t think the transactions side of our business will change
SHEVON: Do you think it would be worthwhile having a consultant advice us on this one? SY, AUTHERINE, AND BEBI (IN UNISON) Why not?
SHEVON: When you do, would you show that individual the following pages that I ripped out from annual
report I just received as a share- holder and see if it has any information value? (see attachment) Required
As a consultant for Anthes Enterprises, identify what you believe are promising hedge accounting options.
Attachment: Torn Pages from the Annual Report of a Major U.S. Manufacturer
First page: Note 10:
We are exposed to the risk of loss arising from adverse changes in:
? commodity prices, affecting the cost of our raw materials and energy, ? foreign exchange risks, ? interest rates, ? stock prices, and ? discount rates affecting the meas- urement of our pension and retiree medical liabilities. In the normal course of business, we manage these risks through a variety of strategies, including the use of derivatives. Certain derivatives are designated as either cash flow or fair value hedges and qualify for hedge accounting
treatment, while others do not qualify and are marked to market through earnings.
For cash flow hedges, changes in fair value are deferred in accumulated other comprehensive loss within shareholders? equity until the underlying hedged item is recognized in net income. For fair value hedges, changes in fair
value are recognized immediately in earnings, consistent with the underly- ing hedged item. Hedging transactions
are limited to an underlying exposure. As a result, any change in the value of our derivative financial instruments
would be substantially offset by an opposite change in the value of the underlying hedged items. Hedging
ineffectiveness and a net earnings impact occur when the change in the value of the hedge does not offset the
change in the value of the underlying hedged item. If the derivative instrument is terminated, we continue to defer the related gain or loss and include it as a component of the cost of the underlying hedged item. Upon
determintation that the hedged item will not be part of an actual transaction, we recognize the related gain or loss in
net income in that period. We also use derivatives that do not qualify for hedge accounting treatment. We account
for such derivatives at market value with the resulting gains and losses reflected in our income statement. We do not
use derivative instruments for trading or speculative purposes and we limit our exposure to individual
counterparties to manage credit risk.
Commodity Prices We are subject to commodity price risk because our ability to recover increased costs through
higher pricing may be limited in the competitive environment in which we operate. This risk is managed through
the use of fixed-price purchase orders, pricing agreements, geographic diversity and derivatives. We use derivatives,
with terms of no more than two years, to economically hedge price fluctuations related to a portion of our
anticipated commodity purchases, primarily for natural gas and diesel fuel. For those derivatives that are designated
as cash flow hedges, any ineffectiveness is recorded immediately. However our commodity cash flow hedges have
not had any significant ineffectiveness for all periods presented. We classify both the earnings and cash flow impact
from these derivatives consistent with the underlying hedged item. During the next 12 months, we expect to
reclassify gains of $24 million related to cash flow hedges from accumulated other comprehensive loss into net
Foreign Exchange Our operations outside of the U.S. generate over a third of our net revenue of which Mexico,
the United Kingdom and Canada com- prise nearly 20%. As a result, we are exposed to foreign currency risks from
unforeseen economic changes and political unrest. On occasion, we enter into hedges, primarily forward contracts
with terms of no more than two years, to reduce the effect of foreign exchange rates. Ineffectiveness on these
hedges has not been material. (rest of page torn off)
Partial second page:
Our Divisions We manufacture or use contract manufacturers, market and sell a variety of slaty, sweet and grainbased snacks, carbonated and non-carbonated beverages, and foods through our North American and international
business divisions. Our North American divi- sions include the United States and Canada. The accounting policies
for the divisions are the same as those described in Note 2, except for certain allocation methodologies for stockbased compensation expense and pension and retiree medical expense, as described in the unaudited information in
?Our Critical Accounting Policies.? Additionally, beginning in the fourth quarter of 2005, we began centrally managing commodity derivatives on behalf of our divisions. Certain of the commodity derivatives, primarily those
related to the purchase of energy for use by our divisions, do not qualify for hedge accounting treatment. These
derivative hedge underlying commodity price risk and were not entered into for speculative purposes. Such
derivatives are our marked to market with the resulting gains and losses recognized as a component of corporate
unallocated expense. These gains and losses are reflected in division results when the divisions take delivery of the
underlying commodity. Therefore, division results reflect the contract purchase price of the energy or other
Division results are based on how Chairman and Chief Executive Officer evaluates our divisions. Division results
exclude certain Corporate-initiated restructuring and impairment charges, merger related costs and divested
businesses. For addition unaudited information on our divisions, see ?Our Operations? in Management?s Discussion
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