O'Reilly Auto Parts 2010 Annual Report Download - page 67

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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. 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. 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. For derivatives with cash flow hedge accounting designation, the Company would recognize the after-tax gain
or loss from the effective portion of the hedge as a component of “Accumulated other comprehensive 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.
At December 31, 2010, the Company held derivative financial instruments to manage interest rate risk. The Company designated
these derivative financial instruments as cash flow hedges. The derivative financial instruments were recorded at fair value and were
included within “Other current liabilities” and “Other liabilities”. Derivative instruments recorded at fair value as liabilities totaled
$4.8 million and $13.1 million as of December 31, 2010 and 2009, respectively. The portion of these derivative instruments included
in “Other current liabilities” totaled $4.8 million and $4.1 million as of December 31, 2010 and 2009, respectively. The portion of
these derivative instruments included in “Other liabilities” totaled $8.9 million 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 indices 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 loss” to “Interest expense”. See Note 8 for
further information concerning these derivative instruments accounted for as hedges.
Income taxes:
The Company accounts for income taxes using the liability method, which requires the recognition of deferred tax assets and liabilities
for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred
tax assets and liabilities are determined based on differences between the GAAP basis and tax basis of assets and liabilities using
enacted tax rules and rates currently scheduled to be in effect for the year in which the differences are expected to reverse. Tax carry
forwards are also recognized in deferred tax assets and liabilities under this method. The effect of a change in tax rates on deferred tax
assets and liabilities is recognized in income in the period of the enactment date. The Company records a valuation allowance against
deferred tax assets to the extent it is more likely than not the amount will not be realized, based upon evidence available at the time of
the determination, and any change in the valuation allowance is recorded in the period of a change in such determination. The
Company has not established a valuation allowance for deferred tax assets at December 31, 2010 and 2009 as it is considered more
likely than not that deferred tax assets are realizable through a combination of future taxable income, the realization of deferred tax
liabilities and tax planning strategies.
Advertising costs:
The Company expenses advertising costs as incurred. Advertising expense included as a component of “Selling, general and
administrative expenses” (“SG&A”) amounted to $70.0 million, $72.9 million and $65.6 million for the years ended December 31,
2010, 2009 and 2008, respectively.
Pre-opening costs:
Costs associated with the opening of new stores, which consist primarily of payroll and occupancy costs, are charged to SG&A as
incurred. Costs associated with the opening of new distribution centers, which consist primarily of payroll and occupancy costs, are
included as a component of “Cost of goods sold, including warehouse and distribution expenses” as incurred.
Share-based compensation plans:
The Company currently sponsors share-based employee benefit plans and stock option plans. The Company recognizes compensation
expense for its share-based payments based on the fair value of the awards on the date of the grant. Share-based payments include
stock option awards issued under the Company’s employee stock option plan, director stock option plan, stock issued through the
Company’s employee stock purchase plan and stock awarded to employees through other benefit programs. See Note 11 for further
information concerning these plans.
Litigation reserves:
O’Reilly is currently involved in litigation incidental to the ordinary conduct of the Company’s business. The Company records
reserves for litigation losses in instances where a material adverse outcome is probable and the Company is able to reasonably
estimate the probable loss. The Company reserves for an estimate of material legal costs to be incurred on pending litigation matters.
Although the Company cannot ascertain the total amount of liability that it may incur from any of these matters, the Company does
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not currently believe that in the aggregate, taking into account applicable insurance coverage, these matters will have a material
adverse effect on its consolidated financial position, results or operations or cash flows. In addition, O’Reilly is involved in resolving
legacy governmental investigations and litigation that were being conducted against certain former CSK employees and CSK arising
out of alleged conduct relating to periods prior to the acquisition. See Note 14 for further information concerning these legal matters.
Closed store liabilities:
The Company maintains reserves for closed stores and other properties that are no longer being utilized in current operations. The
Company provides for these liabilities using a credit-adjusted discount rate to calculate the present value of the remaining non-
cancelable lease payments, occupancy costs and lease termination fees after the close date, net of estimated sublease income. In
conjunction with the acquisition of CSK, the Company’s reserves include purchase accounting liabilities related to acquired properties
that were no longer being utilized in the acquired business as well as the Company’s planned exit activities. See Note 7 for further
information concerning these liabilities.
Earnings per share:
Basic earnings per share is based on the weighted-average outstanding common shares. Diluted earnings per share is based on the
weighted-average outstanding shares as well as the effect of common stock equivalents. Common stock equivalents that could
potentially dilute basic earnings per share in the future that were not included in the fully diluted computation because they would
have been antidilutive were 1.4 million, 1.6 million and 7.4 million for the years ended December 31, 2010, 2009 and 2008,
respectively. See Note 12 for further information concerning these common stock equivalents.
Concentration of credit risk:
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents,
accounts receivable, notes receivable and variable rate debt.
The Company grants credit to certain customers who meet the Company’s pre-established credit requirements. Concentrations of
credit risk with respect to these receivables are limited because the Company’s customer base consists of a large number of smaller
customers, spreading the credit risk across a broad base. The Company also controls this credit risk through credit approvals, credit
limits and accounts receivable and credit monitoring procedures. Generally, the Company does not require security when credit is
granted to customers. Credit losses are provided for in the Company’s consolidated financial statements and have consistently been
within management’s expectations.
The Company has entered into various derivative financial instruments to mitigate the risk of interest rate fluctuations on its variable
rate long-term debt. If the market interest rate on the Company’s net derivative positions with counterparties exceeds a specified
threshold, the counterparty is required to transfer cash in excess of the threshold to the Company. Conversely, if the market value of
the net derivative positions falls below a specified threshold, the Company is required to transfer cash below the threshold to the
counterparty. The Company is exposed to credit loss in the event of nonperformance by counterparties on derivative contracts used in
these hedging activities. The counterparties to the Company’s derivative contracts are major financial institutions and the Company
has not historically experienced nonperformance by any of its counterparties.
New accounting pronouncements:
In January of 2010, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2010-06, Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (“ASU 2010-06”). ASU 2010-06 amends Subtopic
820-10, requiring additional disclosures regarding fair value measurements such as transfers in and out of Levels 1 and 2, as well as
separate disclosures about activity relating to Level 3 measurements. ASU 2010-06 clarifies existing disclosure requirements related
to the level of disaggregation and input valuation techniques. The updated guidance is effective for interim and annual periods
beginning after December 15, 2009, with the exception of the new Level 3 activity disclosures, which are effective for interim and
annual periods beginning after December 15, 2010. The adoption of the new guidance did not have a material impact on the
Company’s consolidated financial position, results of operations or cash flows. The adoption of the new Level 3 guidance is required
in 2011 and is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash
flows.
Subsequent events:
On January 11, 2011, the Company announced a new Board-approved share repurchase program (the “Repurchase Program”) that
authorizes the Company to repurchase up to $500 million of shares of common stock over a three-year period. Stock repurchases
under the Repurchase Program may be made from time to time as the Company deems appropriate, solely through open market
purchases effected through a broker dealer at prevailing market prices, and the Company may increase or otherwise modify the
Repurchase Program at any time without prior notice.
On January 14, 2011, the Company issued $500 million aggregate principal amount of unsecured 4.875% Senior Notes due 2021 in
the public market, of which the Company and its subsidiaries are the guarantors, and UMB Bank, N.A. (“UMB”) is trustee. The 2011
4.875% Senior Notes were issued at 99.297% of their face value and will mature on January 14, 2021. The proceeds from the 2011
FORM 10-K