IBM 2010 Annual Report Download - page 78

Notes to Consolidated Financial Statements
International Business Machines Corporation and Subsidiary Companies76
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 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
accumulated other comprehensive income/(loss), a component
of 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 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 accumulated other comprehensive
income/(loss) in the Consolidated Statement of Changes in 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.
If 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
designated as net investment hedges and derivatives that do not
qualify as hedges are reported in cash flows from investing activities.
For currency swaps designated as hedges of foreign currency
denominated debt (included in the company’s debt risk manage-
ment program as addressed in note L, “Derivative Financial
Instruments,” on pages 96 through 101), cash flows directly associ-
ated with the settlement of the principal element of these swaps
are reported in payments to settle debt in cash flows from financing
activities in the Consolidated Statement of Cash Flows.
Financial Instruments
In determining the 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.
Refer to note E, “Financial Instruments (Excluding Derivatives),” on
pages 88 and 89 for further information. All methods of assessing
fair value result in a general approximation of value, and such value
may never actually be realized.
Fair Value Measurement
Exit prices are used to measure assets and liabilities that fall within
the scope of the fair value measurements guidance. Under this
guidance, the company is required to classify certain assets and
liabilities based on the following fair value hierarchy:
• Level 1—Quoted prices in active markets that are unadjusted
and accessible at the measurement date for identical, unre-
stricted assets or liabilities;
• Level 2—Quoted prices for identical assets and liabilities
in markets that are not active, quoted prices for similar assets
and liabilities in active markets or financial instruments
for which significant inputs are observable, either directly or
indirectly; and
• Level 3—Prices or valuations that require inputs that are both
significant to the fair value measurement and unobservable.
The guidance requires the use of observable market data if such
data is available without undue cost and effort.
When available, the company uses unadjusted quoted market
prices to measure the fair value and classifies such items within
Level 1. If quoted market prices are not available, fair value is based
upon internally developed models that use current market-based
or independently sourced market parameters such as interest
rates and currency rates. Items valued using internally generated
models are classified according to the lowest level input or value
driver that is significant to the valuation.
The determination of fair value considers various factors
including interest rate yield curves and time value underlying the
financial instruments. For derivatives and debt securities, the
company uses a discounted cash flow analysis using discount
rates commensurate with the duration of the instrument.