BP 2013 Annual Report Download - page 137

1. Significant accounting policies, judgements, estimates and assumptions – continued
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.
Significant estimate or judgement
The decision as to whether to apply hedge accounting or not can have a significant impact on the group’s financial statements. Cash flow and fair
value hedge accounting is applied to certain of the group’s finance debt-related derivatives in the normal course of business. In addition, the financial
statements reflect the application of cash flow hedge accounting to certain of the contracts signed in October 2012 for BP to sell its investment in
TNK-BP and obtain an additional shareholding in Rosneft, which were accounted for as derivatives under IFRS. We applied ‘all-in-one’ cash flow
hedge accounting to the contracts to acquire shares in Rosneft, resulting in a pre-tax loss of $2,061 million being recognized in other comprehensive
income for the year (2012 pre-tax gain of $1,410 million). See Note 26 for further information.
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.
Fair value measurement
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The
group categorizes assets and liabilities measured at fair value into one of three levels depending on the ability to observe inputs employed in their
measurement. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Level 2 inputs are inputs that are observable, either
directly or indirectly, other than quoted prices included within level 1 for the asset or liability. Level 3 inputs are unobservable inputs for the asset or
liability reflecting significant modifications to observable related market data or BP’s assumptions about pricing by market participants.
Significant estimate or judgement
In some cases the fair values of derivatives are estimated using internal models due to the absence of quoted prices or other observable, market-
corroborated data. This applies to the group’s longer-term derivative contracts and certain options, and to the forward contracts entered into in 2012
to purchase shares in Rosneft, as well as to the majority of the group’s natural gas embedded contracts. The group’s embedded derivatives arise
primarily from long-term UK gas contracts that use pricing formulae not related to gas prices, for example, oil product and power prices. These
contracts are valued using models with inputs that include price curves for each of the different products that are built up from active market pricing
data and extrapolated to the expiry of the contracts using the maximum available external pricing information. Additionally, where limited data exists
for certain products, prices are interpolated using historic and long-term pricing relationships. Price volatility is also an input for the models.
Changes in the key assumptions could have a material impact on the fair value gains and losses on derivatives and embedded derivatives recognized
in the income statement. For more information see Note 26.
Offsetting of financial assets and liabilities
Financial assets and liabilities are presented gross in the balance sheet unless both of the following criteria are met: the group currently has a legally
enforceable right to set off the recognized amounts; and the group intends to either settle on a net basis or realize the asset and settle the liability
simultaneously. If both of the criteria are met, the amounts are set off and presented net.
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
Financial statements
BP Annual Report and Form 20-F 2013 133