IBM 2012 Annual Report Download - page 85

84 Notes to Consolidated Financial Statements
International Business Machines Corporation and Subsidiary Companies
84
Financial Instruments
In determining the fair value of its financial instruments, the com-
pany uses a variety of methods and assumptions that are based
on market conditions and risks existing at each balance sheet
date. See note D, “Financial Instruments,” on pages 92 to 94 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
Accounting guidance defines fair value as the price that would be
received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
Under this guidance, the company is required to classify certain
assets and liabilities based on the following fair value hierarchy:
• Level 1—Quoted prices (unadjusted) in active markets
for identical assets or liabilities that can be accessed
at the measurement date;
• Level 2—Inputs other than quoted prices included within
Level 1 that are observable for the asset or liability, either
directly or indirectly; and
• Level 3—Unobservable inputs for the asset or liability.
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 in active markets 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 includ-
ing 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.
In determining the fair value of financial instruments, the com-
pany considers certain market valuation adjustments to the “base
valuations” calculated using the methodologies described below
for several parameters that market participants would consider in
determining fair value:
• Counterparty credit risk adjustments are applied to financial
instruments, taking into account the actual credit risk of a
counterparty as observed in the credit default swap market
to determine the true fair value of such an instrument.
• Credit risk adjustments are applied to reflect the company’s
own credit risk when valuing all liabilities measured at
fair value. The methodology is consistent with that applied
in developing counterparty credit risk adjustments, but
incorporates the company’s own credit risk as observed
in the credit default swap market.
As an example, the fair value of derivatives is derived utilizing a
discounted cash flow model that uses observable market inputs
such as known notional value amounts, yield curves, spot and
forward exchange rates as well as discount rates. These inputs relate
to liquid, heavily traded currencies with active markets which are
available for the full term of the derivative.
Certain financial assets are measured at fair value on a nonrecur-
ring basis. These assets include equity method investments that are
recognized at fair value at the measurement date to the extent that
they are deemed to be other-than-temporarily impaired. Certain
assets that are measured at fair value on a recurring basis can be
subject to nonrecurring fair value measurements. These assets
include available-for-sale equity investments that are deemed to
be other-than-temporarily impaired. In the event of an other-than-
temporary impairment of a financial instrument, fair value is measured
using a model described above.
Accounting guidance permits the measurement of eligible finan-
cial assets, financial liabilities and firm commitments at fair value, on
an instrument-by-instrument basis, that are otherwise not permitted
to be accounted for at fair value under other accounting standards.
This election is irrevocable. The company does not apply the fair
value option to any eligible assets or liabilities.
Cash Equivalents
All highly liquid investments with maturities of three months or less at
the date of purchase are considered to be cash equivalents.
Marketable Securities
Debt securities included in current assets represent securities that
are expected to be realized in cash within one year of the balance
sheet date. Long-term debt securities that are not expected to be
realized in cash within one year and alliance equity securities are
included in investments and sundry assets. Debt and marketable
equity securities are considered available for sale and are reported
at fair value with unrealized gains and losses, net of applicable taxes,
in OCI. The realized gains and losses for available-for-sale securities
are included in other (income) and expense in the Consolidated
Statement of Earnings. Realized gains and losses are calculated
based on the specific identification method.