Banana Republic 2007 Annual Report Download - page 25

being recognized in the financial statements and provides guidance on derecognition, measurement,
classification, interest and penalties, accounting in interim periods, disclosure and transition issues. To the extent
that our estimates change or the final tax outcome of these matters is different than the amounts recorded, such
differences will impact the income tax provision in the period in which such determinations are made. We also
record a valuation allowance against our deferred tax assets arising from certain net operating losses when it is
more likely than not that some portion or all of such net operating losses will not be realized. Our effective tax rate
in a given financial statement period may be materially impacted by changes in the mix and level of earnings,
changes in the expected outcome of audits or changes in the deferred tax valuation allowance.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 1 of Notes to the Consolidated Financial Statements for recent accounting pronouncements, including
the expected dates of adoption and estimated effects on our financial position, statement of cash flows and
results of operations.
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Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We operate in foreign countries, which exposes us to market risk associated with foreign currency exchange rate
fluctuations. Our risk management policy is to hedge a significant portion of forecasted merchandise purchases
for foreign operations and forecasted royalty payments using foreign exchange forward contracts. We also use
forward contracts to hedge our market risk exposure associated with foreign currency exchange rate fluctuations
for certain intercompany loans and balances denominated in currencies other than the functional currency of the
entity holding or issuing the intercompany loan or balance. These contracts are entered into with large, reputable
financial institutions, which are monitored for counterparty risk. The principal currencies hedged during fiscal 2007
were the Euro, British pound, Japanese yen, and Canadian dollar. Our use of derivative financial instruments
represents risk management; we do not use derivative financial instruments for trading purposes. Additional
information is presented in Note 7 of Notes to the Consolidated Financial Statements.
We also use forward contracts to hedge the net assets of an international subsidiary to offset the translation and
economic exposures related to our investment in that subsidiary. The change in fair value of the forward contracts
is reported in accumulated other comprehensive earnings within stockholders’ equity to offset the foreign currency
translation adjustments on the investment.
We have performed a sensitivity analysis as of February 2, 2008 and February 3, 2007, based on a model that
measures the impact of a hypothetical 10 percent adverse change in the level of foreign currency exchange rates
to the U.S. dollar (with all other variables held constant) on our underlying exposure, net of derivative financial
instruments. The foreign currency exchange rates used in the model were based on the spot rates in effect at
February 2, 2008 and February 3, 2007. The sensitivity analysis indicated that a hypothetical 10 percent adverse
movement in foreign currency exchange rates would have had an unfavorable impact on the underlying cash flow
exposure, net of our foreign exchange derivative financial instruments, of $37 million at February 2, 2008 and $20
million at February 3, 2007.
We have limited exposure to interest rate fluctuations on our borrowings. We use a cross-currency interest rate
swap to swap the interest and principal payable of $50 million debt securities of our Japanese subsidiary, Gap
(Japan) KK, due March 2009, from a fixed interest rate of 6.25 percent, payable in U.S. dollars, to 6.1 billion
Japanese yen with a fixed interest rate of 2.43 percent. These debt securities are recorded on the Consolidated
Balance Sheets at their issuance amount, net of unamortized discount. The fair value of this long-term debt was
$51 million and $50 million as of February 2, 2008 and February 3, 2007, respectively.
The interest on our $500 million notes payable due December 2008, of which only $138 million remains
outstanding, is subject to increase (decrease) by 0.25 percent for each rating downgrade (upgrade) of our long-
term senior unsecured debt ratings by rating agencies. The interest payable by us on the notes was 10.05 percent
per annum as of February 2, 2008. The fair value of the notes payable as of February 2, 2008 and February 3,
2007 was $144 million and $147 million, respectively.
In addition, we have fixed and variable income investments classified as cash, cash equivalents and short-term
investments. Primarily all securities held are U.S. government and agency securities, domestic commercial paper,
and bank securities and are stated at amortized cost, which approximates fair market value due to the short
maturities of these instruments. An increase in interest rates of 10 percent would not have a material impact on
the value of these investments. However, declines in interest rates would decrease the interest income derived
from our investments. We earned interest income of $117 million, $131 million, and $93 million in fiscal 2007,
2006, and 2005, respectively.
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