Prudential 2003 Annual Report Download - page 109

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PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
purpose subsidiary. Additionally, derivatives may be used to seek to reduce exposure to interest rate and foreign
currency risks associated with assets held or expected to be purchased or sold, and liabilities incurred or expected to be
incurred.
Derivatives are recorded in the Consolidated Statements of Financial Position either as assets, within “Trading
account assets,” “Broker-dealer related receivables,” or “Other long-term investments,” or as liabilities, within
“Broker-dealer related payables” or “Other liabilities.” Realized and unrealized changes in fair value of derivatives
used in a dealer capacity are included in “Commissions and other income” in the Consolidated Statements of
Operations 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.
As discussed in detail below and in Note 18, all realized and unrealized changes in fair value of non-dealer related
derivatives, with the exception of the effective unrealized portion of cash flow hedges and effective hedges of net
investments in foreign operations, are recorded in current earnings. Cash flows from these derivatives are reported in
the investing activities section in the Consolidated Statements of Cash Flows.
For non-dealer related derivatives 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 of adjusting the derivative to fair value is recorded in
“Realized investment gains (losses), net.”
The Company formally documents 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.
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 line item associated with the hedged item. Under
certain circumstances, the change in fair value of an unhedged item is either not recorded or recorded instead in
“Accumulated other comprehensive income (loss).” When such items are hedged and the hedge qualifies as a fair value
hedge, the change in fair value of both the hedged item and the derivative are reported on a net basis in “Realized
investment gains (losses), net.” Periodic settlements associated with such derivatives 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 “Accumulated other comprehensive income (loss)” until earnings are affected by the variability
of cash flows (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.
Prudential Financial 2003 Annual Report 107