Prudential 2012 Annual Report Download - page 123

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
2. SIGNIFICANT ACCOUNTING POLICIES AND PRONOUNCEMENTS (continued)
securities and commodities. The Company’s global commodities group was sold on July 1, 2011. See Note 3 for further details. Realized
and unrealized changes in fair value of derivatives used in these dealer related operations are included in “Income from discontinued
operations, net of taxes” in the periods in which the changes occur. Cash flows from such derivatives are reported in the operating activities
section of the Consolidated Statements of Cash Flows.
Derivatives are recorded either as assets, within “Other trading account assets, at fair value” or “Other long-term investments,” or as
liabilities, within “Other liabilities,” except for embedded derivatives which are recorded with the associated host contract. The Company
nets the fair value of all derivative financial instruments with counterparties for which a master netting arrangement has been executed.
The Company designates derivatives as either (1) a hedge of the fair value of a recognized asset or liability or unrecognized firm
commitment (“fair value” hedge); (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to
a recognized asset or liability (“cash flow” hedge); (3) a foreign-currency fair value or cash flow hedge (“foreign currency” hedge); (4) a
hedge of a net investment in a foreign operation; or (5) a derivative that does not qualify for hedge accounting.
To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated risk of the hedged item.
Effectiveness of the hedge is formally assessed at inception and throughout the life of the hedging relationship. Even if a derivative
qualifies for hedge accounting treatment, there may be an element of ineffectiveness of the hedge. Under such circumstances, the
ineffective portion is recorded in “Realized investment gains (losses), net.”
The Company formally documents at inception all relationships between hedging instruments and hedged items, as well as its risk-
management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives designated as
fair value, cash flow, or foreign currency hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or
forecasted transactions. Hedges of a net investment in a foreign operation are linked to the specific foreign operation.
When a derivative is designated as a fair value hedge and is determined to be highly effective, changes in its fair value, along with
changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are reported on a net basis in the
income statement, generally in “Realized investment gains (losses), net.” When swaps are used in hedge accounting relationships, periodic
settlements are recorded in the same income statement line as the related settlements of the hedged items.
When a derivative is designated as a cash flow hedge and is determined to be highly effective, changes in its fair value are recorded in
AOCI until earnings are affected by the variability of cash flows being hedged (e.g., when periodic settlements on a variable-rate asset or
liability are recorded in earnings). At that time, the related portion of deferred gains or losses on the derivative instrument is reclassified
and reported in the income statement line item associated with the hedged item.
When a derivative is designated as a foreign currency hedge and is determined to be highly effective, changes in its fair value are
recorded either in current period earnings if the hedge transaction is a fair value hedge (e.g., a hedge of a recognized foreign currency asset
or liability) or in AOCI if the hedge transaction is a cash flow hedge (e.g., a foreign currency denominated forecasted transaction). When a
derivative is used as a hedge of a net investment in a foreign operation, its change in fair value, to the extent effective as a hedge, is
recorded in the cumulative translation adjustment account within AOCI.
If it is determined that a derivative no longer qualifies as an effective fair value or cash flow hedge or management removes the hedge
designation, the derivative will continue to be carried on the balance sheet at its fair value, with changes in fair value recognized currently
in “Realized investment gains (losses), net.” In this scenario, the hedged asset or liability under a fair value hedge will no longer be
adjusted for changes in fair value and the existing basis adjustment is amortized to the income statement line associated with the asset or
liability. The component of AOCI related to discontinued cash flow hedges is reclassified to the income statement line associated with the
hedged cash flows consistent with the earnings impact of the original hedged cash flows.
When hedge accounting is discontinued because the hedged item no longer meets the definition of a firm commitment, or because it is
probable that the forecasted transaction will not occur by the end of the specified time period, the derivative will continue to be carried on
the balance sheet at its fair value, with changes in fair value recognized currently in “Realized investment gains (losses), net.” Any asset or
liability that was recorded pursuant to recognition of the firm commitment is removed from the balance sheet and recognized currently in
“Realized investment gains (losses), net.” Gains and losses that were in AOCI pursuant to the hedge of a forecasted transaction are
recognized immediately in “Realized investment gains (losses), net.”
If a derivative does not qualify for hedge accounting, all changes in its fair value, including net receipts and payments, are included in
“Realized investment gains (losses), net” without considering changes in the fair value of the economically associated assets or liabilities.
The Company is a party to financial instruments that contain derivative instruments that are “embedded” in the financial instruments.
At inception, the Company assesses whether the economic characteristics of the embedded instrument are clearly and closely related to the
economic characteristics of the remaining component of the financial instrument (i.e., the host contract) and whether a separate instrument
with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that (1) the
embedded instrument possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host
contract, and (2) a separate instrument with the same terms would qualify as a derivative instrument, the embedded instrument qualifies as
an embedded derivative that is separated from the host contract, carried at fair value, and changes in its fair value are included in “Realized
investment gains (losses), net.” For certain financial instruments that contain an embedded derivative that otherwise would need to be
bifurcated and reported at fair value, the Company may elect to classify the entire instrument as a trading account asset and report it within
“Other trading account assets, at fair value.”
Prudential Financial, Inc. 2012 Annual Report 121