Johnson Controls 2012 Annual Report Download - page 48

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48
is deemed as highly effective if the ratio is between 80% and 125%. For commodity derivative contracts designated
as cash flow hedges, effectiveness is tested using a regression calculation. Ineffectiveness is minimal as the
Company aligns most of the critical terms of its derivatives with the supply contracts.
For net investment hedges, the Company assesses its net investment positions in the non-U.S. operations and
compares it with the outstanding net investment hedges on a quarterly basis. The hedge is deemed effective if the
aggregate outstanding principal of the hedge instruments designated as the net investment hedge in a non-U.S.
operation does not exceed the Company’s net investment positions in the respective non-U.S. operation.
The Company selectively uses interest rate swaps to reduce market risk associated with changes in interest rates for
its fixed-rate bonds. For the five fixed to floating interest rate swaps totaling $450 million to hedge the coupon of its
1.75% notes maturing March 2014, the Company elected the short cut method as the criteria to apply the short cut
method as defined in ASC 815 was met and the critical terms for both the hedge and underlying hedged item are
identical at inception of the hedge and the presented reporting periods. In applying the short cut method, the
Company is allowed to assume zero ineffectiveness without performing detailed effectiveness assessments and does
not record any ineffectiveness related to the hedge relationship. For remaining interest rate swaps, the long-haul
method is used. The Company therefore assesses retrospective and prospective effectiveness on a quarterly basis and
records any measured ineffectiveness in the consolidated statements of income.
Equity swaps and any other derivative instruments not designated as hedging instruments under ASC 815 require no
assessment of effectiveness on a quarterly basis.
A discussion of the Company’s accounting policies for derivative financial instruments is included in Note 1,
―Summary of Significant Accounting Policies,‖ of the notes to consolidated financial statements, and further
disclosure relating to derivatives and hedging activities is included in Note 9, ―Derivative Instruments and Hedging
Activities,‖ and Note 10, ―Fair Value Measurements,‖ of the notes to consolidated financial statements.
Foreign Exchange
The Company has manufacturing, sales and distribution facilities around the world and thus makes investments and
enters into transactions denominated in various foreign currencies. In order to maintain strict control and achieve the
benefits of the Company’s global diversification, foreign exchange exposures for each currency are netted internally
so that only its net foreign exchange exposures are, as appropriate, hedged with financial instruments.
The Company hedges 70% to 90% of the nominal amount of each of its known foreign exchange transactional
exposures. The Company primarily enters into foreign currency exchange contracts to reduce the earnings and cash
flow impact of the variation of non-functional currency denominated receivables and payables. Gains and losses
resulting from hedging instruments offset the foreign exchange gains or losses on the underlying assets and
liabilities being hedged. The maturities of the forward exchange contracts generally coincide with the settlement
dates of the related transactions. Realized and unrealized gains and losses on these contracts are recognized in the
same period as gains and losses on the hedged items. The Company also selectively hedges anticipated transactions
that are subject to foreign exchange exposure, primarily with foreign currency exchange contracts, which are
designated as cash flow hedges in accordance with ASC 815. At September 30, 2012 and 2011, the Company
estimates that an unfavorable 10% change in the exchange rates would have decreased net unrealized gains by
approximately $23 million and $54 million, respectively.
The Company has entered into cross-currency interest rate swaps to selectively hedge portions of its net investment
in Japan. The currency effects of the cross-currency interest rate swaps are reflected in the accumulated other
comprehensive income (AOCI) account within shareholders’ equity attributable to Johnson Controls, Inc. where
they offset gains and losses recorded on the Company’s net investment in Japan.
Interest Rates
The Company uses interest rate swaps to offset its exposure to interest rate movements. In accordance with ASC
815, these outstanding swaps qualify and are designated as fair value hedges. As of September 30, 2012, the
Company had eight interest rate swaps totaling $850 million outstanding. A 10% increase in the average cost of the
Company’s variable rate debt would result in an unfavorable change in pre-tax interest expense of approximately $3
million and $5 million at September 30, 2012 and 2011, respectively.