IBM 2003 Annual Report Download - page 86

hedges at the inception of the contract. These criteria
demonstrate that the derivative is expected to be highly
effective at offsetting changes in fair value or cash flows of
the underlying exposure both at inception of the hedging
relationship and on an ongoing basis. The assessment for
effectiveness is formally documented at hedge inception
and reviewed at least quarterly throughout the designated
hedge period.
The company applies hedge accounting in accordance
with SFAS No. 133, whereby the company designates each
derivative as a hedge of: (1) the fair value of a recognized asset
or liability or of an unrecognized firm commitment (“fair
value” hedge); (2) the variability of anticipated cash flows of
a forecasted transaction or the cash flows to be received or
paid related to a recognized asset or liability (“cash flow”
hedge); or (3) a hedge of a long-term investment (“net invest-
ment” hedge) in a foreign operation. From time to time,
however, the company may enter into derivatives that eco-
nomically hedge certain of its risks, even though hedge
accounting does not apply under SFAS No. 133 or is not
applied by the company. In these cases, there generally exists
a natural hedging relationship in which changes in fair value
of the derivative, which are recognized currently in net
income, act as an economic offset to changes in the fair value
of the underlying hedged item(s).
Changes in the value of a derivative that is designated as
a fair value hedge, along with offsetting changes in the fair
value of the underlying hedged exposure, are recorded in
earnings each period. For hedges of interest rate risk, the fair
value adjustments are recorded as adjustments to Interest
expense and Cost of Global Financing in the Consolidated
Statement of Earnings. For hedges of currency risk associ-
ated with recorded assets or liabilities, derivative fair value
adjustments generally are recognized in Other (income) and
expense in the Consolidated Statement of Earnings.
Changes in the value of a derivative that is designated as a
cash flow hedge are recorded, net of applicable taxes, in the
Accumulated gains and (losses) not affecting retained earn-
ings, a component of Stockholders’ equity. When net income
is affected by the variability of the underlying cash flow, the
applicable offsetting amount of the gain or loss from the
derivative that is deferred in Stockholders’ equity is released
to net income and reported in Interest expense, Cost, SG&A
expense or Other (income) and expense in the Consolidated
Statement of Earnings based on the nature of the underlying
cash flow hedged. Effectiveness for net investment hedging
derivatives is measured on a spot to spot basis. The effective
portion of changes in the fair value of net investment hedg-
ing derivatives and other non-derivative risk management
instruments designated as net investment hedges are recorded
as foreign currency translation adjustments, net of applica-
ble taxes, in the Accumulated gains and (losses) not affecting
retained earnings section of Stockholders’ equity. Changes in
the fair value of the portion of a net investment hedging
derivative excluded from the effectiveness assessment are
recorded in Interest expense.
When the underlying hedged item ceases to exist, all
changes in the fair value of the derivative are included in net
income each period until the instrument matures. When the
derivative transaction ceases to exist, a hedged asset or lia-
bility is no longer adjusted for changes in its fair value except
as required under other relevant accounting standards.
Derivatives that are not designated as hedges, as well as
changes in the value of derivatives that do not offset the
underlying hedged item throughout the designated hedge
period (collectively, “ineffectiveness”), are recorded in net
income each period and generally are reported in Other
(income) and expense.
The company generally reports cash flows resulting from
the company’s derivative financial instruments consistent
with the classification of cash flows from the underlying
hedged items that the derivatives are hedging. Accordingly,
the majority of cash flows associated with the company’s
derivative programs are classified in Cash flows from operat-
ing activities in the Consolidated Statement of Cash Flows.
For currency swaps designated as hedges of foreign currency
denominated debt (included in the company’s debt risk man-
agement program as addressed in note L, “Derivatives and
Hedging Transactions,” on pages 96 to 99), cash flows directly
associated with the settlement of the principal element of
these swaps are reported in the Payment to settle debt line in
the Cash flow from financing activities section of the
Consolidated Statement of Cash Flows.
See note L, “Derivatives and Hedging Transactions,” on
pages 96 to 99 for a description of the major risk manage-
ment programs and classes of financial instruments used by
the company.
FINANCIAL INSTRUMENTS
In determining fair value of its financial instruments, the
company uses a variety of methods and assumptions that are
based on market conditions and risks existing at each balance
sheet date. For the majority of financial instruments including
most derivatives, long-term investments and long-term
debt, standard market conventions and techniques such as
discounted cash flow analysis, option pricing models,
replacement cost and termination cost are used to determine
fair value. Dealer quotes are used for the remaining financial
instruments. All methods of assessing fair value result in a
general approximation of value, and such value may never
actually be realized.
CASH EQUIVALENTS
All highly liquid investments with maturities of three
months or less at the date of purchase are carried at fair value
and considered to be cash equivalents.
Notes to Consolidated Financial Statements
INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES
84