O'Reilly Auto Parts 2009 Annual Report Download - page 64

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Operating Leases
The Company’s policy is to amortize leasehold improvements over the lesser of the lease term or the estimated economic life of those
assets. Generally, the lease term for stores is the base lease term and the lease term for distribution centers includes the base lease term
plus certain renewal option periods for which renewal is reasonably assured and failure to exercise the renewal option would result in a
significant economic penalty. The Company recognizes rent expense on a straight-line basis over these lease terms.
Notes Receivable
The Company had notes receivable from vendors and other third parties amounting to $16,591,000 and $28,221,000 at December 31,
2009 and 2008, respectively. The notes receivable, which bear interest at rates ranging from 0% to 10%, are due in varying amounts
through August 2017.
Self-Insurance Reserves
The Company uses a combination of insurance and self-insurance mechanisms to provide for the potential liabilities for workers’
compensation, general liability, vehicle liability, property loss, and employee health care benefits. With the exception of employee
health care benefit liabilities, which are limited by the design of these plans, the Company obtains third-party insurance coverage to
limit its exposure. The Company estimates its self-insurance liabilities by considering a number of factors, including historical claims
experience and trend-lines, projected medical and legal inflation, and growth patterns and exposure forecasts. These liabilities are
recorded at their net present value.
Warranty Costs
The Company offers warranties on the merchandise it sells with warranty periods ranging from 30 days to lifetime, limited warranties.
The risk of loss arising from warranty claims is typically the obligation of the Company’s vendors, but for a small portion of
merchandise sold, the Company bears the risk of loss associated with the cost of warranty claims. Estimated warranty costs, which are
recorded as obligations at the time of sale, are based on the historical failure rate of each individual product line. The Company’s
historical experience has been that failure rates are relatively consistent over time and that the ultimate cost of warranty claims to the
Company has been driven by volume of units sold as opposed to fluctuations in failure rates or the variation of the cost of individual
claims. To the extent vendors provide upfront allowances in lieu of accepting the obligation for warranty claims and the allowance is
in excess of the related warranty expense, the excess is recorded as a reduction to cost of sales.
Derivative Instruments and Hedging Activities
The Company’s accounting policies for derivative financial instruments are based on whether the instruments meet the criteria for
designation as cash flow or fair value hedges. A designated hedge of the exposure to variability in the future cash flows of an asset or
a liability qualifies as a cash flow hedge. A designated hedge of the exposure to changes in fair value of an asset or a liability qualifies
as a fair value hedge. The criteria for designating a derivative as a hedge include the assessment of the instrument’s effectiveness in
risk reduction, matching of the derivative instrument to its underlying transaction and the probability that the underlying transaction
will occur. For derivatives with cash flow hedge accounting designation, the Company reports the after-tax gain or loss from the
effective portion of the hedge as a component of accumulated other comprehensive income (loss) and reclassifies it into earnings in the
same period or periods in which the hedged transaction affects earnings, and within the same income statement line item as the impact
of the hedged transaction. For derivatives with fair value hedge accounting designation, the Company would recognize gains or losses
from the change in fair value of these derivatives, as well as the offsetting change in the fair value of the underlying hedged item, in
earnings.
The Company currently holds derivative financial instruments to manage interest rate risk. The Company has designated these
derivative financial instruments as cash flow hedges. The derivative financial instruments are recorded at fair value and are included in
“Other liabilities and “Other long-term liabilities”. Derivative instruments recorded at fair value as liabilities totaled $13,053,000 and
$18,874,000 as of December 31, 2009 and 2008, respectively. Derivative instruments included in “Other liabilities” totaled
$4,140,000 and $18,874,000 as of December 31, 2009 and 2008, respectively. Derivative instruments included in “Other long-term
liabilities” totaled $8,913,000 as of December 31, 2009. On a quarterly basis, the Company measures the effectiveness of the
derivative financial instruments by comparing the present value of the cumulative change in the expected future interest to be paid or
received on the variable leg of the instruments against the expected future interest payments on the corresponding variable rate debt.
In addition, the Company compares the critical terms, including notional amounts, underlying indexes and reset dates of the derivative
financial instruments with the respective variable rate debt to ensure all terms agree. Any ineffectiveness would be reclassified from
“Accumulated other comprehensive income (loss)” to “Interest expense.” As of December 31, 2009, the Company had no