This excerpt taken from the FL 10-K filed Mar 29, 2005.
Foreign Exchange Risk Management
The Company operates internationally and utilizes certain derivative financial instruments to mitigate its foreign currency exposures, primarily related to third party and intercompany forecasted transactions. Also, the Company mitigates the effect of fluctuating foreign exchange rates on the reporting of foreign currency denominated earnings. Such strategies may at times include holding a variety of derivative instruments, which includes entering into forwards and option contracts, whereby the changes in the fair value of these financial instruments are charged to the statements of operations immediately. For a derivative to qualify as a hedge at inception and throughout the hedged period, the Company formally documents the nature and relationships between the hedging instruments and hedged items, as well as its risk-management objectives, strategies for undertaking the various hedge transactions and the methods of assessing hedge effectiveness and hedge ineffectiveness. Additionally, for hedges of forecasted transactions, the significant characteristics and expected terms of a forecasted transaction must be specifically identified, and it must be probable that each forecasted transaction would occur. If it were deemed probable that the forecasted transaction would not occur, the gain or loss would be recognized in earnings immediately. No such gains or losses were recognized in earnings during 2004 or 2003.
Derivative financial instruments qualifying for hedge accounting must maintain a specified level of effectiveness between the hedging instrument and the item being hedged, both at inception and throughout the hedged period, which management evaluates periodically.
The primary currencies to which the Company is exposed are the euro, the British Pound and the Canadian Dollar. When using a forward contract as a hedging instrument, the Company excludes the time value from the assessment of effectiveness. The change in a forward contracts time value is reported in earnings. For forward foreign exchange contracts designated as cash flow hedges of inventory, the effective portion of gains and losses is deferred as a component of accumulated other comprehensive loss and is recognized as a component of cost of sales when the related inventory is sold. Amounts classified to cost of sales related to such contracts were a loss of approximately $1 million in 2004 and a gain of $2 million in 2003. The ineffective portion of gains and losses related to cash flow hedges recorded to earnings in 2004 was approximately $1 million and was not significant in 2003. The Company also enters into other forward contracts to hedge intercompany royalty cash flows that are denominated in foreign currencies. The effective portion of gains and losses associated with these forward contracts is reclassified from accumulated other comprehensive loss to selling, general and administrative expenses in the same quarter as the underlying intercompany royalty transaction occurs and were not significant for any of the periods presented.
At each year-end, the Company had not hedged forecasted transactions for more than the next twelve months, and the Company expects all derivative-related amounts reported in accumulated other comprehensive loss to be reclassified to earnings within twelve months.
The changes in fair value of forward contracts and option contracts that do not qualify as hedges are recorded in earnings. In 2004, the Company entered into certain forward foreign exchange contracts to hedge intercompany foreign-currency denominated firm commitments and recorded losses of approximately $2 million in selling, general and administrative expenses to reflect their fair value. These losses were offset by the foreign exchange gains on the revaluation of the underlying commitments, which were expected to be settled in 2004 and 2005.
In 2003, the Company recorded a gain of approximately $7 million for the change in fair value of derivative instruments not designated as hedges, which was offset by a foreign exchange loss related to the underlying transactions. These amounts were primarily related to the intercompany foreign-currency denominated firm commitments, as the gains on the other forward contracts were not significant.
The fair value of derivative contracts outstanding at January 29, 2005 comprised other assets of $2 million and current liabilities of $3 million. The fair value of derivative contracts outstanding at January 31, 2004 comprised current assets of $1 million, current liabilities of $3 million, and other liabilities of $1 million.