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International Accounting 7th Ed.

Chapter 11 Financial Risk Management

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 currencies.

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 Enterprises 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 well land the con- tract. Things move a little slowly over there and theyre still concerned about some of the legal details of our sales contract. I think they find the legalese a bit intimidating and I cant say I blame them. Ive scheduled another trip next month to go over contract details. This time Im taking our legal counsel and have asked him to prepare another draft expressed in terms that are easier to understand. Theyre 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, weve 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, weve written a put option on the koruna for 90 days.

SHEVON: Do we think well close on the deal before then?

BEBI: Autherine doesnt think so, but you never know. The problem is no one will write an option for a longer term. Well 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: Hows that?

SY: It looks like were 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 wont be able to treat gains or losses on our put options as a part of comprehensive income, but well have to recognize them in current earnings.

SHEVON: Wont that mess up our bottom line?

SY: Im afraid so. There would be no offsetting gain or loss from our anticipated sale.

BEBI: Its taken me a whole year to get to know the right people and win their trust and friendship. I now have that. Theres 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 cant find anyone whos willing to write an option for more than 90 days at a time.

SHEVON: I dont want to think about what the accounting will do to our stock price! I mean, were 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 dont think the transactions side of our business will change much.

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 deriv- atives. Certain derivatives are desig- nated as either cash flow or fair value hedges and qualify for hedge account- ing 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 share- holders 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 treat- ment. 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 diver- sity 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 compre- hensive loss into net income.

Foreign Exchange Our operations out- side 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 grain-based 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 stock- based compensation expense and pen- sion 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 man- aging commodity derivatives on behalf of our divisions. Certain of the commod- ity 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 commodities.

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 Managements Discussion and Analysis.