Pepsi 2005 Annual Report Download - page 70

68
Most long-term contractual commit-
ments, except for our long-term debt
obligations, are not recorded in our
Consolidated Balance Sheet. Non-cance-
lable operating leases primarily represent
building leases. Non-cancelable purchasing
commitments are primarily for oranges and
orange juices to be used for our Tropicana
brand beverages. Non-cancelable marketing
commitments primarily are for sports
marketing and with our fountain customers.
Bottler funding is not reflected in our
long-term contractual commitments as it is
negotiated on an annual basis. See Note 7
regarding our pension and retiree medical
obligations and discussion below regarding
our commitments to noncontrolled bottling
affiliates and former restaurant operations.
Off-Balance Sheet Arrangements
It is not our business practice to enter into
off-balance sheet arrangements, other than
in the normal course of business, nor is
it our policy to issue guarantees to our
bottlers, noncontrolled affiliates or third
parties. However, certain guarantees were
necessary to facilitate the separation of our
bottling and restaurant operations from us.
In connection with these transactions, we
have guaranteed $2.3 billion of Bottling
Group, LLC’s long-term debt through 2012
and $28 million of YUM! Brands, Inc.
(YUM) outstanding obligations, primarily
property leases, through 2020. The terms
of our Bottling Group, LLC debt guarantee
are intended to preserve the structure of
PBG’s separation from us and our payment
obligation would be triggered if Bottling
Group, LLC failed to perform under these
debt obligations or the structure signifi-
cantly changed. Our guarantees of certain
obligations ensured YUM’s continued use of
certain properties. These guarantees would
require our cash payment if YUM failed to
perform under these lease obligations.
See “Our Liquidity, Capital Resources
and Financial Position” in Management’s
Discussion and Analysis for further
unaudited information on our borrowings.
We are exposed to the risk of loss arising
from adverse changes in:
• commodity prices, affecting the cost of
our raw materials and energy,
• foreign exchange risks,
• interest rates,
• stock prices, and
• discount rates affecting the measure-
ment of our pension and retiree medical
liabilities.
In the normal course of business, we
manage these risks through a variety of
strategies, including the use of derivatives.
Certain derivatives are designated as either
cash flow or fair value hedges and qualify
for hedge accounting treatment, while oth-
ers do not qualify and are marked to market
through earnings. See “Our Business
Risks” in Management’s Discussion and
Analysis for further unaudited information
on our business risks.
For cash flow hedges, changes in fair
value are deferred in accumulated other
comprehensive loss within shareholders’
equity until the underlying hedged item is
recognized in net income. For fair value
hedges, changes in fair value are recognized
immediately in earnings, consistent with the
underlying hedged item. Hedging transac-
tions are limited to an underlying exposure.
As a result, any change in the value of our
derivative instruments would be substan-
tially offset by an opposite change in the
value of the underlying hedged items.
Hedging ineffectiveness and a net earnings
impact occur when the change in the value
of the hedge does not offset the change in
the value of the underlying hedged item. If
the derivative instrument is terminated, we
continue to defer the related gain or loss
and include it as a component of the cost of
the underlying hedged item. Upon determi-
nation that the underlying hedged item
will not be part of an actual transaction, we
recognize the related gain or loss in net
income in that period.
We also use derivatives that do not
qualify for hedge accounting treatment.
We account for such derivatives at market
value with the resulting gains and losses
reflected in our income statement. We do
not use derivative instruments for trading
or speculative purposes and we limit our
exposure to individual counterparties to
manage credit risk.
Commodity Prices
We are subject to commodity price risk
because our ability to recover increased
costs through higher pricing may be
limited in the competitive environment in
which we operate. This risk is managed
through the use of fixed-price purchase
orders, pricing agreements, geographic
diversity and derivatives. We use deriva-
tives, with terms of no more than two
years, to economically hedge price fluctua-
tions related to a portion of our anticipated
commodity purchases, primarily for natural
gas and diesel fuel. For those derivatives
that are designated as cash flow hedges,
any ineffectiveness is recorded immedi-
ately. However, our commodity cash flow
hedges have not had any significant inef-
fectiveness for all periods presented. We
classify both the earnings and cash flow
impact from these derivatives consistent
with the underlying hedged item. During
the next 12 months, we expect to reclas-
sify gains of $24 million related to cash
flow hedges from accumulated other
comprehensive loss into net income.
Foreign Exchange
Our operations outside of the U.S. generate
over a third of our net revenue of which
Mexico, the United Kingdom and Canada
comprise nearly 20%. As a result, we are
exposed to foreign currency risks from
unforeseen economic changes and political
unrest. On occasion, we enter into hedges,
primarily forward contracts with terms of no
more than two years, to reduce the effect of
foreign exchange rates. Ineffectiveness on
these hedges has not been material.
Interest Rates
We centrally manage our debt and invest-
ment portfolios considering investment
opportunities and risks, tax consequences
and overall financing strategies. We may
use interest rate and cross currency
interest rate swaps to manage our overall
interest expense and foreign exchange risk.
These instruments effectively change the
interest rate and currency of specific debt
issuances. These swaps are entered into
Note 10 — Risk Management