BP 2012 Annual Report Download - page 192

1. Significant accounting policies continued
Derivative financial instruments and hedging activities
The group uses derivative financial instruments to manage certain
exposures to fluctuations in foreign currency exchange rates, interest
rates and commodity prices as well as for trading purposes. Such
derivative financial instruments are initially recognized at fair value on the
date on which a derivative contract is entered into and are subsequently
remeasured at fair value. Derivatives relating to unquoted equity
instruments are carried at cost where it is not possible to reliably measure
their fair value subsequent to initial recognition. Derivatives are carried as
assets when the fair value is positive and as liabilities when the fair value
is negative.
Contracts to buy or sell a non-financial item that can be settled net in cash
or another financial instrument, or by exchanging financial instruments as
if the contracts were financial instruments, with the exception of contracts
that were entered into and continue to be held for the purpose of the
receipt or delivery of a non-financial item in accordance with the group’s
expected purchase, sale or usage requirements, are accounted for as
financial instruments. Contracts to buy or sell equity investments,
including investments in associates, are also financial instruments.
Gains or losses arising from changes in the fair value of derivatives that
are not designated as effective hedging instruments are recognized in the
income statement.
For the purpose of hedge accounting, hedges are classified as:
• Fair value hedges when hedging exposure to changes in the fair value
of a recognized asset or liability.
• Cash flow hedges when hedging exposure to variability in cash flows
that is either attributable to a particular risk associated with a recognized
asset or liability or a highly probable forecast transaction.
Hedge relationships are formally designated and documented at inception,
together with the risk management objective and strategy for undertaking
the hedge. The documentation includes identification of the hedging
instrument, the hedged item or transaction, the nature of the risk being
hedged, and how the entity will assess the hedging instrument
effectiveness in offsetting the exposure to changes in the hedged item’s
fair value or cash flows attributable to the hedged item. Such hedges are
expected at inception to be highly effective in achieving offsetting
changes in fair value or cash flows. Hedges meeting the criteria for hedge
accounting are accounted for as follows:
Fair value hedges
The change in fair value of a hedging derivative is recognized in profit or
loss. The change in the fair value of the hedged item attributable to the
risk being hedged is recorded as part of the carrying value of the hedged
item and is also recognized in profit or loss.
The group applies fair value hedge accounting for hedging fixed interest
rate risk on borrowings. The gain or loss relating to the effective portion of
the interest rate swap is recognized in the income statement within
finance costs, offsetting the amortization of the interest on the underlying
borrowings.
If the criteria for hedge accounting are no longer met, or if the group
revokes the designation, the adjustment to the carrying amount of a
hedged item for which the effective interest method is used is amortized
to profit or loss over the period to maturity.
Cash flow hedges
For cash flow hedges, the effective portion of the gain or loss on the
hedging instrument is recognized within other comprehensive income,
while the ineffective portion is recognized in profit or loss. Amounts taken
to other comprehensive income are transferred to the income statement
when the hedged transaction affects profit or loss. The gain or loss
relating to the effective portion of interest rate swaps hedging variable
rate borrowings is recognized in the income statement within finance
costs.
Where the hedged item is the cost of a non-financial asset or liability, such
as a forecast transaction for the purchase of property, plant and
equipment, the amounts recognized within other comprehensive income
are transferred to the initial carrying amount of the non-financial asset or
liability. Where the hedged item is an equity investment, such as an
investment in an associate, the amounts recognized in other
comprehensive income remain in the separate component of equity until
the investment is sold or impaired.
If the hedging instrument expires or is sold, terminated or exercised
without replacement or rollover, or if its designation as a hedge is
revoked, amounts previously recognized within other comprehensive
income remain in equity until the forecast transaction occurs and are
transferred to the income statement or to the initial carrying amount of a
non-financial asset or liability as above. If a forecast transaction is no
longer expected to occur, amounts previously recognized in equity are
reclassified to the income statement.
Embedded derivatives
Derivatives embedded in other financial instruments or other host
contracts are treated as separate derivatives when their risks and
characteristics are not closely related to those of the host contract.
Contracts are assessed for embedded derivatives when the group
becomes a party to them, including at the date of a business combination.
Embedded derivatives are measured at fair value at each balance sheet
date. Any gains or losses arising from changes in fair value are taken
directly to the income statement.
Provisions, contingencies and reimbursement assets
Provisions are recognized when the group has a present obligation (legal
or constructive) as a result of a past event, it is probable that an outflow of
resources embodying economic benefits will be required to settle the
obligation and a reliable estimate can be made of the amount of the
obligation. Where appropriate, the future cash flow estimates are adjusted
to reflect risks specific to the liability.
If the effect of the time value of money is material, provisions are
determined by discounting the expected future cash flows at a pre-tax
risk-free rate that reflects current market assessments of the time value
of money. Where discounting is used, the increase in the provision due to
the passage of time is recognized within finance costs. Provisions are split
between amounts expected to be settled within 12 months of the balance
sheet date (current) and amounts expected to be settled later (non-
current). Contingent liabilities are possible obligations whose existence
will only be confirmed by future events not wholly within the control of
the group, or present obligations where it is not probable that an outflow
of resources will be required or the amount of the obligation cannot be
measured with sufficient reliability.
Contingent liabilities are not recognized in the financial statements but are
disclosed unless the possibility of an outflow of economic resources is
considered remote.
Where the group makes contributions into a separately administered fund
for restoration, environmental or other obligations, which it does not
control, and the group’s right to the assets in the fund is restricted, the
obligation to contribute to the fund is recognized as a liability where it is
probable that such additional contributions will be made. The group
recognizes a reimbursement asset separately, being the lower of the
amount of the associated restoration, environmental or other provision
and the group’s share of the fair value of the net assets of the fund
available to contributors.
Decommissioning
Liabilities for decommissioning costs are recognized when the group has
an obligation to plug and abandon a well, dismantle and remove a facility
or an item of plant and to restore the site on which it is located, and when
a reliable estimate of that liability can be made. Where an obligation exists
for a new facility or item of plant, such as oil and natural gas production or
transportation facilities, this liability will be recognized on construction or
installation. Similarly, where an obligation exists for a well, this liability is
recognized when it is drilled. An obligation for decommissioning may also
crystallize during the period of operation of a well, facility or item of plant
through a change in legislation or through a decision to terminate
operations. The amount recognized is the present value of the estimated
future expenditure determined in accordance with local conditions and
requirements.
A corresponding intangible asset (in the case of an exploration or appraisal
well) or item of property, plant and equipment of an amount equivalent to
the provision is also recognized. The item of property, plant and
equipment is subsequently depreciated as part of the asset.
190 Financial statements
BP Annual Report and Form 20-F 2012