IBM 2008 Annual Report Download - page 75

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Notes to Consolidated Financial Statements
INTERNATIONAL BUSINESS MACHINES CORPORATION and Subsidiary Companies
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 the approxi-
mate 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.
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All derivatives are recognized in the Consolidated Statement of Finan-
cial 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 matu-
rity of the instrument is less than or greater than  months. To qualify
for hedge accounting in accordance with SFAS No. , “Accounting
for Derivative Instruments and Hedging Activities,” as amended by
SFAS No. , “Accounting for Certain Derivative Instruments and
Certain Hedging Activities,” SFAS No. , “Amendment of State-
ment  on Derivative Instruments and Hedging Activities,” and
SFAS No. , “Accounting for Certain Hybrid Financial Instru ments
— An Amendment of FASB Statements No.  and ” (collec-
tively, “SFAS No. ”), 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. , whereby the company designates each derivative as a hedge
of: () the fair value of a recognized financial asset or liability or of an
unrecognized firm commitment (fair value hedge); () the variability
of anticipated cash flows of a forecasted transaction or the cash flows
to be received or paid related to a recognized financial asset or liabil-
ity (cash flow hedge); or () 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. .
In these cases, there exists a natural hedging relationship in which
changes in the fair value of the derivative, which are recognized cur-
rently 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 Consoli-
dated Statement of Earnings. For hedges of currency risk associated
with recorded financial assets or liabilities, derivative fair value
adjustments are recognized in other (income) and expense in the
Consolidated Statement of Earnings. Changes in the fair value of a
derivative that is designated as a cash flow hedge are recorded, net of
applicable taxes, in the accumulated gains and
(l osses) not affecting
retained earnings, 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
hedging derivatives and other non-derivative financial instruments
designated as net investment hedges are recorded as foreign currency
translation adjustments, net of applicable taxes, in the accumulated
gains and
(l osses) not affecting retained earnings section of the
Consolidated Statement 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 liability 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 fair value of derivatives that do not effectively offset
changes in the fair value of the underlying hedged item throughout
the designated hedge period (collectively, “ineffectiveness”), are
recorded in net income each period and are reported in other
(income) and expense.
The company reports cash flows arising from derivative financial
instruments designated as fair value or cash flow hedges consistent
with the classification of cash flows from the underlying hedged
items that these derivatives are hedging. Accordingly, the cash flows
associated with derivatives designated as fair value or cash flow
hedges are classified in cash flows from operating activities in the
Consolidated Statement of Cash Flows. Cash flows from derivatives