IBM 2007 Annual Report Download - page 91

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Notes to Consolidated Financial Statements
International Business Machines Corporation and Subsidiary Companies
Long-Term Investments in Foreign Subsidiaries
(Net Investment)
A significant portion of the company’s foreign currency denominated
debt portfolio is designated as a hedge of net investment which
reduces the volatility in stockholders’ equity caused by changes in
foreign currency exchange rates in the functional currency of major
foreign subsidiaries with respect to the U.S. dollar. The company
also uses currency swaps and foreign exchange forward contracts for
this risk management purpose, as well as a component of its debt
management program. The currency effects of these hedges (approx-
imately $880 million losses in 2007, $350 million losses in 2006 and
$570 million gains in 2005, net of tax) were reflected in the
Accumulated gains and (losses) not affecting retained earnings section
of the Consolidated Statement of Stockholders’ Equity, thereby
offsetting a portion of the translation adjustment of the applicable
foreign subsidiaries’ net assets.
Anticipated Royalties and Cost Transactions
The company’s operations generate significant nonfunctional cur-
rency, third-party vendor payments and intercompany payments for
royalties and goods and services among the company’s non-U.S.
subsidiaries and with the parent company. In anticipation of these
foreign currency cash flows and in view of the volatility of the cur-
rency markets, the company selectively employs foreign exchange
forward contracts to manage its currency risk. These forwards are
accounted for as cash flow hedges. The maximum length of time
over which the company is hedging its exposure to the variability in
future cash flows is approximately four years. At December 31,
2007, the weighted-average remaining maturity of these derivative
instruments was approximately 281 days, as compared to 216 days
at December 31, 2006.
Anticipated Commodity Purchase Transactions
In connection with the purchase of electricity for anticipated manu-
facturing requirements, the company selectively employs forward
contracts to manage its price risk. The forwards are accounted for as
cash flow hedges. The company does not have any derivative instru-
ments relating to this program outstanding at December 31, 2007.
Subsidiary Cash and Foreign Currency Asset/
Liability Management
The company uses its Global Treasury Centers to manage the cash of
its subsidiaries. These centers principally use currency swaps to con-
vert cash flows in a cost-effective manner. In addition, the company
uses foreign exchange forward contracts to economically hedge, on a
net basis, the foreign currency exposure of a portion of the company’s
nonfunctional currency assets and liabilities. The terms of these for-
ward and swap contracts are generally less than one year. The changes
in the fair values of these contracts and of the underlying hedged
exposures are generally offsetting and are recorded in Other (income)
and expense in the Consolidated Statement of Earnings.
Equity Risk Management
The company is exposed to equity price changes related to certain
obligations to employees. These equity exposures are primarily
related to market price movements in certain broad equity market
indices and in the company’s common stock. Changes in the overall
value of these employee compensation obligations are recorded in
SG&A expense in the Consolidated Statement of Earnings. Although
not designated as accounting hedges, the company utilizes equity
derivatives, including equity swaps and futures, to economically hedge
the exposures related to certain employee compensation obligations.
The derivatives are linked to the total return on certain broad equity
market indices or the total return on the company’s common stock.
They are recorded at fair value with gains or losses also reported in
SG&A expense in the Consolidated Statement of Earnings.
Other Derivatives
The company holds warrants in connection with certain investments
that are deemed derivatives because they contain net share or net
cash settlement provisions. The company records the changes in the
fair value of these warrants in Other (income) and expense in the
Consolidated Statement of Earnings.
The company is exposed to a potential loss if a client fails to pay
amounts due under contractual terms (“credit risk”). The company
utilizes credit default swaps to economically hedge its credit exposures.
These derivatives have remaining terms of one year or less. The swaps
are recorded at fair value with gains and losses reported in Other
(income) and expense in the Consolidated Statement of Earnings.
To economically hedge its foreign exchange exposure not covered
by any of the previously discussed programs, the company also uses
certain forward and option contracts that are not designated as
accounting hedges. These derivatives are recorded at fair value with
gains and losses reported in Other (income) and expense in the
Consolidated Statement of Earnings.