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Notes to Consolidated Financial Statements

Note 10. Financial Instruments

We are exposed to market risks arising from adverse changes in:

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 others do not qualify and are marked to market through earnings. Cash flows from derivatives used to manage commodity, foreign exchange or interest risks are classified as operating activities. 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 transactions are limited to an underlying exposure. As a result, any change in the value of our derivative instruments would be substantially 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 determination 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. We perform a quarterly assessment of our counterparty credit risk, including a review of credit ratings, credit default swap rates and potential nonperformance of the counterparty. We consider this risk to be low, because we limit our exposure to individual, strong creditworthy counterparties and generally settle on a net basis.

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 derivatives, with terms of no more than three years, to economically hedge price fluctuations related to a portion of our anticipated commodity purchases, primarily for natural gas and diesel fuel. For those derivatives that qualify for hedge accounting, any ineffectiveness is recorded immediately. However, such commodity cash flow hedges have not had any significant ineffectiveness 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 reclassify net losses of $64 million related to cash flow hedges from accumulated other comprehensive loss into net income. Derivatives used to hedge commodity price risks that do not qualify for hedge accounting are marked to market each period and reflected in our income statement.

In 2007, we expanded our commodity hedging program to include derivative contracts used to mitigate our exposure to price changes associated with our purchases of fruit. In addition, in 2008, we entered into additional contracts to further reduce our exposure to price fluctuations in our raw material and energy costs. The majority of these contracts do not qualify for hedge accounting treatment and are marked to market with the resulting gains and losses recognized in corporate unallocated expenses. These gains and losses are then subsequently reflected in divisional results.

Our open commodity derivative contracts that qualify for hedge accounting had a face value of $303 million at December 27, 2008 and $5 million at December 29, 2007. These contracts resulted in net unrealized losses of $117 million at December 27, 2008 and net unrealized gains of less than $1 million at December 29, 2007.

Our open commodity derivative contracts that do not qualify for hedge accounting had a face value of $626 million at December 27, 2008 and $105 million at December 29, 2007. These contracts resulted in net losses of $343 million in 2008 and net gains of $3 million in 2007.

Foreign Exchange

Our operations outside of the U.S. generate 48% of our net revenue, with Mexico, Canada and the United Kingdom comprising 19% of our net revenue. As a result, we are exposed to foreign currency risks. 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 of these hedges has not been material.

Interest Rates

We centrally manage our debt and investment 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. Our 2008 and 2007 interest rate swaps were entered into concurrently with the issuance of the debt that they modified. The notional amount, interest payment and maturity date of the swaps match the principal, interest payment and maturity date of the related debt.

Fair Value

In September 2006, the FASB issued SFAS 157, Fair Value Measurements (SFAS 157), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS 157 were effective as of the beginning of our 2008 fiscal year. However, the FASB deferred the effective date of SFAS 157, until the beginning of our 2009 fiscal year, as it relates to fair value measurement requirements for nonfinancial assets and liabilities that are not remeasured at fair value on a recurring basis. These include goodwill, other nonamortizable intangible assets and unallocated purchase price for recent acquisitions which are included within other assets. We adopted SFAS 157 at the beginning of our 2008 fiscal year and our adoption did not have a material impact on our financial statements.

The fair value framework requires the categorization of assets and liabilities into three levels based upon the assumptions (inputs) used to price the assets or liabilities. Level 1 provides the most reliable measure of fair value, whereas Level 3 generally requires significant management judgment. The three levels are defined as follows:

The fair values of our financial assets and liabilities are categorized as follows:

                             
         
2008
       
2007
 
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Assets
                             
Short-term investments – index funds(a)
$
98
 
$
98
 
$
 
$
 
$
189
 
Available-for-sale securities(b)
 
41
   
41
   
   
   
74
 
Forward exchange contracts(c)
 
139
   
   
139
   
   
32
 
Commodity contracts – other(d)
 
   
   
   
   
10
 
Interest rate swaps(e)
 
372
   
   
372
   
   
36
 
Prepaid forward contracts(f)
 
41
   
   
41
   
   
74
 
Total assets at fair value
$
691
 
$
139
 
$
552
 
$
 
$
415
 
Liabilities
                             
Forward exchange contracts(c)
$
56
 
$
 
$
56
 
$
 
$
61
 
Commodity contracts – futures(g)
 
115
   
115
   
   
   
 
Commodity contracts – other(d)
 
345
   
   
345
   
   
7
 
Cross currency interest rate swaps(h)
 
   
   
   
   
8
 
Deferred compensation(i)
 
447
   
99
   
348
   
   
564
 
Total liabilities at fair value
$
963
 
$
214
 
$
749
 
$
 
$
640
 
The above items are included on our balance sheet under the captions noted or as indicated below. In addition, derivatives qualify for hedge accounting unless otherwise noted below.
(a) Based on price changes in index funds used to manage a portion of market risk arising from our deferred compensation liability.
(b) Based on the price of common stock.
(c) Based on observable market transactions of spot and forward rates. The 2008 asset includes $27 million related to derivatives that do not qualify for hedge accounting and the 2008 liability includes $55 million related to derivatives that do not qualify for hedge accounting. The 2007 asset includes $20 million related to derivatives that do not qualify for hedge accounting and the 2007 liability includes $5 million related to derivatives that do not qualify for hedge accounting.
(d) Based on recently reported transactions in the marketplace, primarily swap arrangements. The 2008 liability includes $292 million related to derivatives that do not qualify for hedge accounting. Our commodity contracts in 2007 did not qualify for hedge accounting.
(e) Based on the LIBOR index.
(f) Based primarily on the price of our common stock.
(g) Based on average prices on futures exchanges. The 2008 liability includes $51 million related to derivatives that do not qualify for hedge accounting.
(h) Based on observable local benchmarks for currency and interest rates. Our cross currency interest rate swaps matured in 2008.
(i) Based on the fair value of investments corresponding to employees’ investment elections.
 

Derivative instruments are recognized on our balance sheet in current assets, current liabilities, other assets or other liabilities at fair value. The carrying amounts of our cash and cash equivalents and short-term investments approximate fair value due to the short term maturity. Short-term investments consist principally of short-term time deposits and index funds of $98 million at December 27, 2008 and $189 million at December 29, 2007 used to manage a portion of market risk arising from our deferred compensation liability.

Under SFAS 157, the fair value of our debt obligations as of December 27, 2008 was $8.8 billion, based upon prices of similar instruments in the market place. The fair value of our debt obligations as of December 29, 2007 was $4.4 billion.

The table above excludes guarantees, including our guarantee aggregating $2.3 billion of Bottling Group, LLC’s long-term debt. The guarantee had a fair value of $117 million at December 27, 2008 and $35 million at December 29, 2007 based on our estimate of the cost to us of transferring the liability to an independent financial institution. See Note 9 for additional information on our guarantees.