Prudential 2005 Annual Report Download - page 96

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
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 “Accumulated other comprehensive income (loss)” 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 in either current period earnings or “Accumulated other comprehensive income (loss),” depending on whether the
hedge transaction is a fair value hedge (e.g., a hedge of a firm commitment that is to be settled in a foreign currency) or 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 “Accumulated other comprehensive income (loss).”
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 may contain derivative instruments that are “embedded” in the financial
instruments. At inception, the Company assesses whether the economic characteristics of the embedded derivative 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 derivative 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 derivative is separated from the host contract, carried at fair value, and changes in its fair
value are included in “Realized investment gains (losses), net.”
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.” The 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 “Accumulated other comprehensive income (loss)” related to discontinued cash flow hedges is
amortized 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 “Accumulated
other comprehensive income (loss)” pursuant to the hedge of a forecasted transaction are recognized immediately in “Realized
investment gains (losses), net.”
In its mortgage operations, the Company enters into commitments to fund commercial mortgage loans at specified interest
rates and other applicable terms within specified periods of time. These commitments are legally binding agreements to extend
credit to a counterparty. Loan commitments for loans that will be held for sale are recognized as derivatives and recorded at fair
value. Beginning in 2004, as a result of Securities and Exchange Commission Staff Accounting Bulletin 105 (“SAB 105”),
“Application of Accounting Principles to Loan Commitments,” in recording such commitments at fair value the Company no longer
recognizes: 1) the initial fair value for those loan commitments where the Company does not have a corresponding investor
purchase commitment for the resulting loan; and 2) the fair value of the future mortgage servicing right (“MSR”) related to the
resulting loan. However, subsequent changes in fair value on loan commitments for loans that will be held for sale, exclusive of
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