IBM 2007 Annual Report Download - page 73

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Notes to Consolidated Financial Statements
International Business Machines Corporation and Subsidiary Companies
Income Taxes
Income tax expense is based on reported income before income taxes.
Deferred income taxes reflect the tax effect of temporary differences
between asset and liability amounts that are recognized for financial
reporting purposes and the amounts that are recognized for income
tax purposes. These deferred taxes are measured by applying currently
enacted tax laws. Valuation allowances are recognized to reduce
deferred tax assets to the amount that will more likely than not be
realized. In assessing the need for a valuation allowance, manage-
ment considers all available evidence including past operating results,
estimates of future taxable income and the feasibility of ongoing tax
planning strategies. When the company changes its determination as
to the amount of deferred tax assets that can be realized, the valuation
allowance is adjusted with a corresponding impact to income tax
expense in the period in which such determination is made.
The company recognizes tax liabilities when, despite the compa-
ny’s belief that its tax return positions are supportable, the company
believes that certain positions may not be fully sustained upon review
by tax authorities. Benefits from tax positions are measured at the
largest amount of benefit that is greater than 50 percent likely of
being realized upon settlement. The current portion of tax liabilities
is included in Taxes and the noncurrent portion of tax liabilities is
included in Other Liabilities in the Consolidated Statement of
Financial Position. To the extent that the final tax outcome of these
matters is different than the amounts recorded, such differences
impact income tax expense in the period in which such determination
is made. Interest and penalties, if any, related to accrued liabilities for
potential tax assessments are included in income tax expense.
Translation of Non-U.S. Currency Amounts
Assets and liabilities of non-U.S. subsidiaries that have a local func-
tional currency are translated to U.S. dollars at year-end exchange
rates. Translation adjustments are recorded in Accumulated gains and
(losses) not affecting retained earnings in the Consolidated Statement
of Stockholders’ Equity. Income and expense items are translated at
weighted-average rates of exchange prevailing during the year.
Inventories, Plant, rental machines and other property — net, and
other non-monetary assets and liabilities of non-U.S. subsidiaries and
branches that operate in U.S. dollars are translated at approximate
exchange rates prevailing when the company acquired the assets or
liabilities. All other assets and liabilities denominated in a currency
other than U.S. dollars are translated at year-end exchange rates with
the transaction gain or loss recognized in Other (income) and expense.
Cost of sales and depreciation are translated at historical exchange
rates. All other income and expense items are translated at the
weighted-average rates of exchange prevailing during the year. These
translation gains and losses are included in Net income for the period
in which exchange rates change.
Derivatives
All derivatives are recognized in the Consolidated Statement of
Financial Position at fair value and are reported in Prepaid expenses
and other current assets, Investments and sundry assets, Other accrued
expenses and liabilities or Other liabilities. Classification of each
derivative as current or noncurrent is based upon whether the maturity
of the instrument is less than or greater than 12 months. To qualify
for hedge accounting in accordance with SFAS No. 133, “Accounting
for Derivative Instruments and Hedging Activities,” as amended by
SFAS No. 138, “Accounting for Certain Derivative Instruments and
Certain Hedging Activities,” SFAS No. 149, “Amendment of Statement
133 on Derivative Instruments and Hedging Activities,” and SFAS
No. 155, “Accounting for Certain Hybrid Financial Instruments —
An Amendment of FASB Statements No. 133 and 140” (collectively,
“SFAS No. 133”), the company requires that the instruments be
effective in reducing the risk exposure that they are designated to
hedge. For instruments that hedge cash flows, hedge effectiveness
criteria also require that it be probable that the underlying transac-
tion will occur. Instruments that meet established accounting criteria
are formally designated as hedges. 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 incep-
tion of the hedging relationship and on an ongoing basis. The method
of assessing hedge effectiveness and measuring hedge ineffectiveness
is formally documented at hedge inception. The company assesses
hedge effectiveness and measures hedge ineffectiveness at least quar-
terly 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 financial asset or liability or of an
unrecognized firm commitment (“fair value” hedge); (2) the variabil-
ity of anticipated cash flows of a forecasted transaction or the cash
flows to be received or paid related to a recognized financial asset or
liability (“cash flow” hedge); or (3) a hedge of a long-term investment
(“net investment” hedge) in a foreign operation. In addition, the
company may enter into derivative contracts that economically
hedge certain of its risks, even though hedge accounting does not
apply or the company elects not to apply hedge accounting under
SFAS No. 133. In these cases, there exists a natural hedging relation-
ship in which changes in the 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 fair 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 Financing in
the Consolidated Statement of Earnings. For hedges of currency risk
associated with recorded financial assets or liabilities, derivative fair