Northrop Grumman 2012 Annual Report Download - page 60

NORTHROP GRUMMAN CORPORATION
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Fair Value of Financial Instruments
The company utilizes fair value measurement guidance prescribed by GAAP to value its financial instruments. The
guidance includes a definition of fair value, prescribes methods for measuring fair value, establishes a fair value
hierarchy based on the inputs used to measure fair value and expands disclosures about the use of fair value
measurements.
The valuation techniques utilized are based upon observable and unobservable inputs. Observable inputs reflect
market data obtained from independent sources, while unobservable inputs reflect internal market assumptions.
These two types of inputs create the following fair value hierarchy:
Level 1 - Quoted prices for identical instruments in active markets.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments
in markets that are not active; and model-derived valuations whose inputs are observable or whose
significant value drivers are observable.
Level 3 - Significant inputs to the valuation model are unobservable.
Marketable securities accounted as trading and available-for-sale are recorded at fair value. For available-for-sale
securities, any changes in unrealized gains and losses are reported as a separate component of other comprehensive
income. Changes in unrealized gains and losses on trading securities are included in other, net in the consolidated
statements of earnings and comprehensive income. In addition, investments in held-to-maturity instruments with
original maturities greater than three months are recorded at amortized cost.
Derivative financial instruments are recognized as assets or liabilities in the financial statements and measured at
fair value. Changes in the fair value of derivative financial instruments that qualify and are designated as fair value
hedges are recorded in earnings from continuing operations, while the effective portion of the changes in the fair
value of derivative financial instruments that qualify and are designated as cash flow hedges are recorded in other
comprehensive income. The company may use derivative financial instruments to manage its exposure to interest
rate and foreign currency exchange risks and to balance its fixed and variable rate long-term debt portfolio. The
company does not use derivative financial instruments for trading or speculative purposes, nor does it use leveraged
financial instruments. Credit risk related to derivative financial instruments is considered minimal and is managed
by requiring high credit standards for counterparties and through periodic settlements of positions. For derivative
financial instruments not designated as cash flow hedging instruments, gains or losses resulting from changes in the
fair value are reported in Other, net in the consolidated statements of earnings and comprehensive income.
Income Taxes
Provisions for federal and foreign income taxes are calculated on reported financial statement pre-tax income based
on current tax law and include the cumulative effect of any changes in tax rates from those used previously in
determining deferred tax assets and liabilities. Such provisions differ from the amounts currently payable because
certain items of income and expense are recognized in different periods for financial reporting purposes than for
income tax purposes. The company recognizes federal interest accrued related to unrecognized tax benefits in
income tax expense. In accordance with industry practice and the regulations that govern the cost accounting
requirements for government contracts, state and local taxes are considered allowable and allocable costs on
government contracts and are therefore recorded in operating costs and expenses. Likewise, the company recognizes
state interest accrued related to unrecognized tax benefits in operating costs and expenses. Federal penalties are
recognized as a component of income tax expense. State and local income and franchise tax provisions are allocable
to government contracts in process and, accordingly, are included in operating income.
Uncertain tax position represents the company’s expected treatment of a tax position taken in a filed tax return, or
planned to be taken in a future tax return or claim, that has not been reflected in measuring income tax expense for
financial reporting purposes. Until these positions are sustained by the taxing authorities or the statute of limitations
concerning such issues lapses, the company does not recognize the tax benefits resulting from such positions and
reports the tax effects as a liability for uncertain tax positions in its consolidated statements of financial position.
Cash and Cash Equivalents
Cash and cash equivalents are comprised of cash in banks and highly liquid instruments with original maturities of
three months or less, primarily consisting of bank time deposits and investments in institutional money market
funds. The company does not invest in high yield or high risk securities. Cash in bank accounts at times may exceed
federally insured limits.