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Financial Instruments and Hedging Activities
6 Months Ended
Jun. 30, 2011
Financial Instruments and Hedging Activities

Financial Instruments and Hedging Activities

The Company is exposed to global market risks, including the effect of changes in interest rates and foreign currency fluctuations. The Company uses foreign currency denominated debt and derivative instruments to mitigate the impact of these changes. The Company does not use derivatives with a level of complexity or with a risk higher than the exposures to be hedged and does not hold or issue derivatives for trading purposes.

 

The Company documents its risk management objective and strategy for undertaking hedging transactions, as well as all relationships between hedging instruments and hedged items. The Company’s derivatives that are designated as hedging instruments consist mainly of interest rate exchange agreements, forward foreign currency exchange agreements and foreign currency options. Interest rate exchange agreements are entered into to manage the interest rate risk associated with the Company’s fixed and floating- rate borrowings. Forward foreign currency exchange agreements and foreign currency options are entered into to mitigate the risk that forecasted foreign currency cash flows (such as royalties denominated in foreign currencies) will be adversely affected by changes in foreign currency exchange rates. Certain foreign currency denominated debt is used, in part, to protect the value of the Company’s investments in certain foreign subsidiaries and affiliates from changes in foreign currency exchange rates.

The Company also enters into certain derivatives that are not designated as hedging instruments. The Company has entered into equity derivative contracts to mitigate market-driven changes in certain of its supplemental benefit plan liabilities. Changes in the fair value of these derivatives are recorded in selling, general & administrative expenses together with the changes in the supplemental benefit plan liabilities. In addition, the Company uses forward foreign currency exchange agreements and foreign currency exchange agreements to mitigate the change in fair value of certain foreign currency denominated assets and liabilities. Since these derivatives are not designated as hedging instruments, the changes in the fair value of these hedges are recognized immediately in nonoperating (income) expense together with the currency gain or loss from the hedged balance sheet position. A portion of the Company’s foreign currency options (more fully described in the Cash Flow Hedging Strategy section) are undesignated as hedging instruments as the underlying foreign currency royalties are earned.

All derivative instruments designated as hedging instruments are classified as fair value, cash flow or net investment hedges. All derivatives (including those not designated as hedging instruments) are recognized on the Consolidated balance sheet at fair value and classified based on the instruments’ maturity date. Changes in the fair value measurements of the derivative instruments are reflected as adjustments to other comprehensive income (OCI) and/or current earnings.

The following table presents the fair values of derivative instruments included on the Consolidated balance sheet:

 

      Derivative Assets      Derivative Liabilities  
In millions    Balance Sheet Classification    June 30,
2011
     December 31,
2010
     Balance Sheet Classification    June 30,
2011
    December 31,
2010
 

Derivatives designated as hedging instruments

                

Foreign currency

  

Prepaid expenses and other current assets

   $ 2.5       $ 7.5      

Accrued payroll and
other liabilities

   $ (2.6   $ (4.6

Interest rate

  

Prepaid expenses and other current assets

     3.0         0.5           

Foreign currency

  

Miscellaneous other assets

     0.3              

Interest rate

  

Miscellaneous other assets

     56.5         72.1      

Other long-term liabilities

     (1.0     (0.3

Total derivatives designated as
hedging instruments

        $ 62.3       $ 80.1            $ (3.6   $ (4.9

Derivatives not designated as
hedging instruments

                
                

Foreign currency

  

Prepaid expenses and other current assets

   $ 16.0       $ 6.0      

Accrued payroll and
other liabilities

   $ (12.2   $ (3.8

Equity

  

Prepaid expenses and other current assets

     127.3         104.4           

Foreign currency

  

Miscellaneous other assets

     2.7         2.7                         

Total derivatives not designated as hedging instruments

        $ 146.0       $ 113.1            $ (12.2   $ (3.8

Total derivatives 1

        $ 208.3       $ 193.2            $ (15.8   $ (8.7

 

(1)

The fair value of derivatives is presented on a gross basis. Accordingly, the 2010 total asset and liability fair values do not agree with the values provided in the Fair Value Measurements note because that disclosure reflects netting adjustments related to specific counterparties of $0.3 million.

 

The following table presents the pretax amounts affecting income and OCI for the six months ended June 30, 2011 and 2010, respectively:

 

In millions                                              

Derivatives in

Fair Value

Hedging

Relationships

     (Gain) Loss
Recognized in Income on
Derivative
   

Hedged Items in

Fair Value

Hedging

Relationships

    (Gain) Loss
Recognized in Income on
Related Hedged Items
 
     2011      2010       2011     2010  
                            

Interest rate

      $ 13.8       $ (15.1     Fixed-rate debt       $ (13.8   $ 15.1   

Derivatives in

Cash flow

Hedging

Relationships

     (Gain) Loss
Recognized in Accumulated
OCI on Derivative
(Effective Portion)
    (Gain) Loss
Reclassified from
Accumulated OCI into
Income (Effective Portion)
    (Gain) Loss
Recognized in Income on
Derivative (Amount Excluded

from Effectiveness Testing and
Ineffective Portion)
 
       2011         2010        2011        2010        2011        2010   
                            

Foreign currency

      $ 5.4       $ (40.7     $                0.2        $                (6.4    $ 6.8      $ 15.4   

Interest rate(1)

            (1.1     (0.3       0.4   

Total

      $ 5.4       $ (40.7     $                (0.9     $                 (6.7    $ 6.8      $ 15.8   

                Net Investment

                Hedging Relationships

     (Gain) Loss
Recognized in Accumulated
OCI on Derivative

(Effective portion)
       (Gain) Loss
Reclassified  from
Accumulated OCI into
Income (Effective Portion)
        

Derivatives Not
Designated as
Hedging

Instruments

   (Gain) Loss
Recognized in
Income
on Derivative
 
     2011      2010        2011      2010           2011      2010  
                                     
                                       

Foreign currency denominated debt

      $ 266.5        $ (225.7              Foreign currency    $ (0.1    $ (14.3

Foreign currency derivatives(2)

       9.4         4.3          $ 8.2            Equity(3)      (11.6      (5.5

Total

      $ 275.9        $ (221.4       $ 8.2       $ -         Total    $ (11.7    $ (19.8

(Gains) losses recognized in income on derivatives are recorded in nonoperating (income) expense unless otherwise noted.

 

(1)

The amount of (gain) loss reclassified from accumulated OCI into income is recorded in Interest expense.

(2) 

The amount of (gain) loss reclassified from accumulated OCI into income is recorded in Impairment and other charges (credits), net.

(3)

The amount of (gain) loss recognized in income on the derivatives used to hedge the supplemental benefit plan liabilities is recorded in Selling, general & administrative expenses.

 

 

Fair Value Hedging Strategy

The Company enters into fair value hedges to reduce the exposure to changes in the fair value of certain liabilities. The fair value hedges the Company enters into consist of interest rate exchange agreements which convert a portion of its fixed-rate debt into floating-rate debt. All of the Company’s interest rate exchange agreements meet the shortcut method requirements. Accordingly, changes in the fair value of the interest rate exchange agreements are exactly offset by changes in the fair value of the underlying debt. No ineffectiveness has been recorded to net income related to interest rate exchange agreements designated as fair value hedges for the six month period ended June 30, 2011. A total of $2.1 billion of the Company’s outstanding fixed-rate debt was effectively converted to floating-rate debt resulting from the use of interest rate exchange agreements.

 

 

Cash Flow Hedging Strategy

The Company enters into cash flow hedges to reduce the exposure to variability in certain expected future cash flows. The types of cash flow hedges the Company enters into include interest rate exchange agreements, forward foreign currency exchange agreements and foreign currency options.

To protect against the reduction in value of forecasted foreign currency cash flows (such as royalties denominated in foreign currencies), the Company uses forward foreign currency exchange agreements and foreign currency options to hedge a portion of anticipated exposures.

 

When the U.S. dollar strengthens against foreign currencies, the decline in present value of future foreign denominated royalties is offset by gains in the fair value of the forward foreign currency exchange agreements and/or foreign currency options. Conversely, when the U.S. dollar weakens, the increase in the present value of future foreign denominated royalties is offset by losses in the fair value of the forward foreign currency exchange agreements and/or foreign currency options.

Although the fair value changes in the foreign currency options may fluctuate over the period of the contract, the Company’s total loss on a foreign currency option is limited to the upfront premium paid for the contract. However, the potential gains on a foreign currency option are unlimited as the settlement value of the contract is based upon the difference between the exchange rate at inception of the contract and the spot exchange rate at maturity. In limited situations, the Company uses foreign currency option collars, which limit the potential gains and lower the upfront premium paid, to protect against currency movements.

The hedges cover the next 18 months for certain exposures and are denominated in various currencies. As of June 30, 2011, the Company had derivatives outstanding with an equivalent notional amount of $305.4 million that were used to hedge a portion of forecasted foreign currency denominated royalties.

The Company excludes the time value of foreign currency options, as well as the discount or premium points on forward foreign currency exchange agreements, from its effectiveness assessment on its cash flow hedges. As a result, changes in the fair value of the derivatives due to these components, as well as the ineffectiveness of the hedges, are recognized in earnings currently. The effective portion of the gains or losses on the derivatives is reported in the deferred hedging adjustment component of OCI in shareholders’ equity and reclassified into earnings in the same period or periods in which the hedged transaction affects earnings.

The Company recorded after tax adjustments related to cash flow hedges to the deferred hedging adjustment component of accumulated OCI in shareholders’ equity. The Company recorded a net decrease of $4.0 million for the six months ended June 30, 2011 and a net increase of $21.8 million for the six months ended June 30, 2010. Based on interest rates and foreign currency exchange rates at June 30, 2011, no significant amount of the $11.0 million in cumulative deferred hedging gains, after tax, at June 30, 2011, will be recognized in earnings over the next 12 months as the underlying hedged transactions are realized.

 

 

Hedge of Net Investment in Foreign Operations Strategy

The Company primarily uses foreign currency denominated debt (third party and intercompany) to hedge its investments in certain foreign subsidiaries and affiliates. Realized and unrealized translation adjustments from these hedges are included in shareholders’ equity in the foreign currency translation component of OCI and offset translation adjustments on the underlying net assets of foreign subsidiaries and affiliates, which also are recorded in OCI. As of June 30, 2011, a total of $5.1 billion of the Company’s outstanding foreign currency denominated debt was designated to hedge investments in certain foreign subsidiaries and affiliates.

 

 

Credit Risk

The Company is exposed to credit-related losses in the event of non-performance by the counterparties to its hedging instruments. The counterparties to these agreements consist of a diverse group of financial institutions. The Company continually monitors its positions and the credit ratings of its counterparties and adjusts positions as appropriate. The Company did not have significant exposure to any individual counterparty at June 30, 2011 and has master agreements that contain netting arrangements. Some of these agreements also require each party to post collateral if credit ratings fall below, or aggregate exposures exceed, certain contractual limits. At June 30, 2011, neither the Company nor its counterparties were required to post collateral on any derivative position, other than on hedges of certain of the Company’s supplemental benefit plan liabilities where its counterparties were required to post collateral on their liability positions.