Hedge Policy Of Avon Products Inc

Published Date: 02 Nov 2017

Avon operates globally, through operations all around the world, and derives app. 83% of its consolidated income from its operations outside of the U.S. One risk connected with Avon’s international operations is that the functional currency for most of its global operations is the appropriate local currency. Because of this, changes in exchange rates may have a considerable impact on its cash flow, assets, earnings and financial position. Currencies for which the company has considerable exposures include for example the Australian dollar, Argentine peso, Brazilian real, Canadian dollar, British pound, Colombian peso, Chinese renminbi, the euro, Philippine peso, Mexican peso, Polish zloty, South Africa rand, Russian ruble, Turkish lira, Venezuelan bolívar and Ukrainian hryvnia. Time by time, the company uses foreign currency hedging and risk management strategies to decrease its exposure to fluctuations in cash flows and earnings linked to movements in foreign exchange rates. There can be no guarantee that foreign currency fluctuations will not have a material unfavourable effect on its business, results of operations and financial condition. (Avon, 2011)

Another risk related to Avon’s international operations is the likelihood that a foreign government may inflict currency remittance restrictions. Due to the likelihood of government restrictions on taking cash out of the country and control of exchange rates, the company may not be able to instantly send home cash at the official exchange rate or if the official exchange rate decreases, it may have a material unfavourable effect on its business, results of operations and financial condition. For example, currency restrictions announced by the Venezuelan government in 2003 have become stricter and have impacted the ability of its Venezuelan subsidiary (Avon Venezuela) to get foreign currency at the official rate to purchase imported products. Unless the situation becomes more favourable, Avon Venezuela’s operations will continue to be negatively affected as it will have to get more of its foreign currency requirements from non-government sources where the exchange rate is worse than the official rate. (Avon, 2011)

Inflation is another risk associated with the company’s international operations. For example, Venezuela has been designated as a highly inflationary economy. Gains and losses resulting from the remeasurement of the financial statements of subsidiaries operating in highly inflationary economies are recorded in earnings. Given Venezuela’s designation as a highly inflationary economy and the devaluation of the official rate, Avon’s revenue, operating profit, and net income will continue to be negatively impacted in 2013 and beyond. In addition, there can be no assurance that other countries in which it operates will not also become highly inflationary and that its operations will not be negatively impacted as a result. (Avon, 2011)

The overall objective of the company’s financial risk management program is to reduce the potential negative effects from changes in foreign exchange and interest rates arising from its business activities. It may reduce its exposure to fluctuations in cash flows associated with changes in interest rates and foreign exchange rates by creating offsetting positions through the use of derivative financial instruments and through operational means. Since Avon uses foreign currency rate-sensitive and interest rate-sensitive instruments to hedge a portion of its existing and forecasted transactions, it expects that any loss in value for the hedge instruments generally would be offset by changes in the value of the underlying transactions. The company doesn’t enter into derivative financial instruments for trading or speculative purposes, nor is it a party to leveraged derivatives. (Avon, 2011)

The company’s hedges of its foreign currency exposure are not designed to, and, therefore, cannot entirely eliminate the effect of changes in foreign exchange rates on its consolidated financial position, results of operations and cash flows. Avon’s foreign-currency financial instruments were analyzed at year-end to determine their sensitivity to foreign exchange rate changes. Based on its foreign exchange contracts at December 31, 2011, the impact of a hypothetical 10% appreciation or 10% depreciation of the U.S. dollar against its foreign exchange contracts would not represent a material potential change in fair value, earnings or cash flows. This potential change does not consider the company’s underlying foreign currency exposures. The hypothetical impact was calculated on the open positions using forward rates at December 31, 2011, adjusted for an assumed 10% appreciation or 10% depreciation of the U.S. dollar against these hedging contracts. (Avon, 2011)

As mentioned previously Avon uses foreign currency-rate sensitive and interest-rate sensitive instruments to hedge a certain portion of its existing and forecasted transactions, it expects that any gain or loss in value of the hedge instruments generally would be offset by decreases or increases in the value of the underlying forecasted transactions. Derivatives are recognized on the balance sheet at their fair values. The following table presents the fair value of derivative instruments outstanding at December 31, 2011:

Table 1: Fair value of derivative instruments outstanding at December 31, 2011

(in million $)derivatives.png

Source: AVON, 2011 p79

When the company becomes a party to a derivative instrument, it designates, for financial reporting purposes, the instrument as a fair value hedge, a cash flow hedge, a net investment hedge, or a non-hedge. The accounting for changes in fair value (gains or losses) of a derivative instrument depends on whether it had designated it and it qualified as part of a hedging relationship and further, on the type of hedging relationship. Changes in the fair value of a derivative that is designated as a fair value hedge, along with the loss or gain on the hedged asset or liability that is attributable to the hedged risk are recorded in earnings. Changes in the fair value of a derivative that is designated as a cash flow hedge are recorded in AOCI to the extent effective and reclassified into earnings in the same period or periods during which the transaction hedged by that derivative also affects earnings. Changes in the fair value of a derivative that is designated as a hedge of a net investment in a foreign operation are recorded in foreign currency translation adjustments within AOCI to the extent effective as a hedge. Changes in the fair value of a derivative not designated as a hedging instrument are recognized in earnings in other expense, net on the Consolidated Statements of Income. Realized gains and losses on a derivative are reported on the Consolidated Statements of Cash Flows consistent with the underlying hedged item. (Avon, 2011)

The company assesses, 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 85% – 125% of the cumulative changes in the fair value of the hedged item. The ineffective portion of a derivative’s gain or loss, if any, is recorded in earnings in other expense, net on the Consolidated Statements of Income. When the company determines that a derivative is not highly effective as a hedge, hedge accounting is discontinued. When it is probable that a hedged forecasted transaction will not occur, Avon discontinues hedge accounting for the affected portion of the forecasted transaction, and reclassifies gains or losses that were accumulated in AOCI to earnings in other expense, net on the Consolidated Statements of Income. (Avon, 2011)

Borrowings are subject to interest rate risk. Avon uses interest-rate swap agreements, which effectively convert the fixed rate on long-term debt to a floating interest rate, to manage its interest rate exposure. The agreements are designated as fair value hedges. The company held interest rate swap agreements that effectively converted approximately 74% at December 31, 2011 and 2010, of its outstanding long-term, fixed rate borrowings to a variable interest rate based on LIBOR. Its total exposure to floating interest rates was approximately 82% at December 31, 2011, and 81% at December 31, 2010. The company had interest-rate swap agreements designated as fair value hedges of fixed-rate debt, with notional amounts totalling $1,725 at December 31, 2011. Unrealized gains were $147.6 at December 31, 2011, and $94.4 at December 31, 2010, and were included within long-term debt. During 2011, it recorded a net gain of $53.2 in interest expense for these interest-rate swap agreements designated as fair value hedges. During 2010, Avon recorded a net gain of $66.8 in interest expense for these interest-rate swap agreements designated as fair value hedges. The impact on interest expense of these interest-rate swap agreements was offset by an equal and offsetting impact in interest expense on the company’s fixed-rate debt. At times, Avon may de-designate the hedging relationship of a receive-fixed/pay-variable interest-rate swap agreement. In these cases, it enters into receive-variable/pay-fixed interest-rate swap agreements that are designated to offset the gain or loss on the de-designated contract. At December 31, 2011, the organization had interest-rate swap agreements that are not designated as hedges with notional amounts totalling $250. Unrealized losses on these agreements were immaterial at December 31, 2011 and 2010. During 2011, the company recorded an immaterial net loss in other expense, net associated with these undesignated interest-rate swap agreements. There was no hedge ineffectiveness for the years ended December 31, 2011, 2010 and 2009, related to these interest rate swaps. (Avon, 2011)

During 2007, the company entered into treasury lock agreements (the "locks") with notional amounts totalling $500.0 that expired on July 31, 2008. The locks were designated as cash flow hedges of the anticipated interest payments on $250.0 principal amount of the 2013 Notes and $250.0 principal amount of the 2018 Notes. The losses on the locks of $38.0 were recorded in AOCI. $19.2 of the losses are being amortized to interest expense over five years and $18.8 are being amortized over ten years. During 2005, Avon entered into treasury lock agreements that it designated as cash flow hedges and used to hedge exposure to a possible rise in interest rates prior to the anticipated issuance of ten- and 30-year bonds. In December 2005, the company decided that a more appropriate strategy was to issue five-year bonds given its 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 AOCI to other expense, net. Upon the change in strategy in December 2005, Avon entered into a treasury lock agreement with a notional amount of $250.0 designated as a cash flow hedge of the $500.0 principal amount of five-year notes payable issued in January 2006. The loss on the 2005 lock agreement of $1.9 was recorded in AOCI and is being amortized to interest expense over five years. During 2003, the company entered into treasury lock agreements that it designated as cash flow hedges and used to hedge the exposure to the possible rise in interest rates prior to the issuance of the 4.625% Notes. The loss of $2.6 was recorded in AOCI and is being amortized to interest expense over ten years. (Avon, 2011)