Canon 2003 Annual Report Download - page 76

74
CANON INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(18) Derivatives and Hedging Activities
Risk management policy
Canon operates internationally, exposing it to the risk of changes in
foreign exchange rates and interest rates. Derivative financial
instruments are comprised principally of foreign exchange contracts
and interest rate swaps utilized by the Company and certain of its
subsidiaries to reduce these risks. Canon assesses foreign currency
exchange rate risk and interest rate risk by continually monitoring
changes in these exposures and by evaluating hedging opportunities.
Canon does not hold or issue derivative financial instruments for
trading purposes. Canon is also exposed to credit-related losses in the
event of non-performance by counterparties to derivative financial
instruments, but it is not expected that any counterparties will fail to
meet their obligations, because most of the counterparties are
internationally recognized financial institutions and contracts are
diversified across a number of major financial institutions.
Foreign currency exchange rate risk management
The major manufacturing bases of Canon are located in Japan and
Asia. The sales generated from overseas are mainly denominated in
U.S. dollar or euro. Therefore, Canon’s international operations
expose Canon to the risk of changes in foreign currency exchange
rates. Canon uses foreign exchange contracts to manage certain
foreign currency exchange exposures principally from the exchange
of U.S. dollar and euro into Japanese yen. These contracts are
primarily used to hedge the foreign currency exposure of forecasted
intercompany sales which are denominated in foreign currencies.
In accordance with Canon’s policy, a specific portion of foreign
currency exposure resulting from forecasted intercompany sales are
hedged using foreign exchange contracts which principally mature
within three months.
Interest rate risk management
Canon’s exposure to the market risk of changes in interest rates
relates primarily to its debt obligations. The fixed-rate debt
obligations expose Canon to variability in their fair values due to
changes in interest rates. To manage the variability in fair values
caused by interest rate changes, Canon enters into interest rate
swaps when it is determined to be appropriate based on market
conditions. The interest rate swaps change the fixed-rate debt
obligations to variable-rate debt obligations by entering into receive-
fixed, pay-variable interest rate swaps. The hedging relationship
between the interest rate swaps and its hedged debt obligations is
highly effective in achieving offsetting changes in fair values
resulting from interest rate risk.
Fair value hedge
Derivative financial instruments designated as fair value hedges
principally relate to interest rate swaps associated with fixed rate
debt obligations. Changes in fair values of the hedged debt
obligations and derivative instruments designated as fair value
hedges of these debt obligations are recognized in other income
(deductions). There is no hedging ineffectiveness or net gains or
losses excluded from the assessment of hedge effectiveness for the
years ended December 31, 2003 and 2002 as the critical terms of
the interest rate swaps match the terms of the hedged debt
obligations.
Cash flow hedge
Changes in the fair value of derivative financial instruments
designated and qualifying as cash flow hedges, including foreign
exchange contracts associated with forecasted intercompany sales
and interest rate swaps associated with variable rate debt obligation,
are reported in accumulated other comprehensive income (loss).
These amounts are subsequently reclassified into earnings through
other income (deductions) in the same period as the hedged items
affect earnings. Substantially all accumulated other comprehensive
income (loss) at year end is expected to be recognized in earnings
over the next twelve months. Canon excludes the time value
component of the hedging instruments from the assessment of
hedge effectiveness.
The effective portions of changes in the fair value of foreign
exchange contracts designated as cash flow hedges and reported in
accumulated other comprehensive income (loss), net of the related
tax effect, are losses of ¥445 million ($4,158 thousand), ¥610
million and ¥6,465 million for the years ended December 31, 2003,
2002 and 2001. The amounts which were reclassified out of
accumulated other comprehensive income (loss) into other income
(deductions), net of the related tax effect, are net losses of ¥674
million ($6,299 thousand), ¥2,699 million and ¥4,042 million for
the years ended December 31, 2003, 2002 and 2001. The amounts
of the hedging ineffectiveness is not material for the years ended
December 31, 2003, 2002 and 2001. The sum of the amount of net
gains or losses excluded from the assessment of hedge
effectiveness which are also recorded in other income (deductions),
net of the related tax effect, are net gains of ¥490 million ($4,579
thousand), ¥668 million and ¥1,907 million for the years ended
December 31, 2003, 2002 and 2001.
Canon has entered into certain foreign exchange contracts
which do not meet the hedging criteria of SFAS 133 and 138. Canon
records these foreign exchange contracts on the balance sheet at fair
value. The changes in fair values are recorded in earnings
immediately. The notional amounts of those foreign exchange
contracts were ¥408,540 million ($3,818,131 thousand) and
¥362,276 million at December 31, 2003 and 2002.
The effective portions of changes in the fair value of interest rate
swap contracts designated as cash flow hedges and reported in
accumulated other comprehensive income (loss), net of the related
t ax effect, is a gain of ¥24 million ($224 thousand) for the year ended
December 31, 2003. The amount which was reclassified out of