Notes to the Consolidated Financial Statements
(Dollars in millions, except per-share data and unless otherwise indicated)
Note 13 – Financial Instruments
We are exposed to market risk from changes in foreign currency exchange rates and interest rates, which could affect operating results, financial position and cash flows. We manage our exposure to these market risks through our regular operating and financing activities and, when appropriate, through the use of derivative financial instruments. These derivative financial instruments are utilized to hedge economic exposures as well as to reduce earnings and cash flow volatility resulting from shifts in market rates. As permitted, certain of these derivative contracts have been designated for hedge accounting treatment under SFAS No. 133. Certain of our derivatives do not qualify for hedge accounting but are effective as economic hedges of our inventory purchases and currency exposure. These derivative contracts are accounted for using the mark-to-market accounting method and accordingly are exposed to some level of volatility. The level of volatility will vary with the type and amount of derivative hedges outstanding, as well as fluctuations in the currency and interest rate market during the period. The related cash flow impacts of all of our derivative activities are reflected as cash flows from operating activities.
We enter into limited types of derivative contracts, including interest rate and cross currency interest rate swap agreements, foreign currency spot, forward and swap contracts and net purchased foreign currency options to manage interest rate and foreign currency exposures. Our primary foreign currency market exposures include the Japanese Yen, Euro, and British pound sterling. The fair market values of all our derivative contracts change with fluctuations in interest rates and/or currency rates and are designed so that any changes in their values are offset by changes in the values of the underlying exposures. Derivative financial instruments are held solely as risk management tools and not for trading or speculative purposes.
By their nature, all derivative instruments involve, to varying degrees, elements of market and credit risk not recognized in our financial statements. The market risk associated with these instruments resulting from currency exchange and interest rate movements is expected to offset the market risk of the underlying transactions, assets and liabilities being hedged. We do not believe there is significant risk of loss in the event of non-performance by the counterparties associated with these instruments because these transactions are executed with a diversified group of major financial institutions. Further, our policy is to deal with counterparties having a minimum investment-grade or better credit rating. Credit risk is managed through the continuous monitoring of exposures to such counterparties.
Interest Rate Risk Management: We use interest rate swap agreements to manage our interest rate exposure and to achieve a desired proportion of variable and fixed rate debt. These derivatives may be designated as fair value hedges or cash flow hedges depending on the nature of the risk being hedged. At December 31, 2007 and 2006, we had outstanding single currency interest rate swap agreements with aggregate notional amounts of $1.1 billion and $1.7 billion, respectively. The net liability fair values at December 31, 2007 and 2006 were $6 and $41, respectively.
Fair Value Hedges: As of December 31, 2007 and 2006, pay variable/receive fixed interest rate swaps with notional amounts of $1.1 billion and $1.4 billion were designated and accounted for as fair value hedges. The swaps were structured to hedge the fair value of related debt by converting them from fixed rate instruments to variable rate instruments. No ineffective portion was recorded to earnings during 2007, 2006, or 2005. The following is a summary of our fair value hedges at December 31, 2007:
| Debt Instrument |
Year First
Designated |
Notional
Amount |
Net
Fair Value |
Weighted
Average Interest Rate Paid |
Interest
Rate Received |
Basis | Maturity | ||||||||||||
| Senior Notes due 2010 | 2003/2005 | $ | 250 | $ | (3 | ) | 8.02 | % | 7.13 | % | Libor | 2010 | |||||||
| Notes due 2016 | 2004 | 250 | (4 | ) | 7.28 | % | 7.20 | % | Libor | 2016 | |||||||||
| Senior Notes due 2011 | 2004 | 125 | (1 | ) | 7.63 | % | 6.88 | % | Libor | 2011 | |||||||||
| Liability to Capital Trust I | 2005 | 450 | 14 | 7.79 | % | 8.00 | % | Libor | 2027 | ||||||||||
| Total | $ | 1,075 | $ | 6 | |||||||||||||||
Cash Flow Hedges: During 2006, pay fixed/receive variable interest rate swaps with notional amounts of £200 million ($392) and a net asset fair value of $1, associated with the U.K. GE secured borrowing were designated and accounted for as cash flow hedges. The swaps were structured to hedge the LIBOR interest rate of the debt by converting it from a variable rate instrument to a fixed rate instrument. The swaps were terminated in connection with the repayment of this borrowing in July 2007. No ineffective portion was recorded to earnings during 2007 and 2006. Refer to Note 4 – Receivables, Net for additional information.
Terminated Swaps: During the period from 2004 to 2007, we terminated interest rate swaps which had been designated as fair value hedges of certain debt instruments. These terminated interest rate swaps had an aggregate notional value of $2.6 billion. The associated net fair value adjustments to the debt instruments are being amortized to interest expense over the remaining term of the related notes. In 2007, 2006 and 2005, the amortization of these fair value adjustments reduced interest expense by $9, $9 and $11, respectively, and we expect to record a net increase to interest expense of $19 in future years through 2027.
Foreign Exchange Risk Management: We may use certain derivative instruments to manage the exposures associated with the foreign currency exchange risks discussed below.
Issuance of foreign currency denominated debt
- We enter into cross-currency interest rate swap agreements to swap the proceeds and related interest payments with a counterparty. In return, we receive and effectively denominate the debt in local functional currencies.
- We utilize forward exchange contracts to hedge the currency exposure for interest payments on foreign currency denominated debt.
- These derivatives may be designated as fair value hedges or cash flow hedges depending on the nature of the risk being hedged.
Foreign currency denominated assets and liabilities
- We generally utilize forward foreign exchange contracts and purchased option contracts to hedge these exposures.
- Changes in the value of these currency derivatives are recorded in earnings together with the offsetting foreign exchange gains and losses on the underlying assets and liabilities.
Purchases of foreign-sourced inventory
- We generally utilize forward foreign exchange contracts and purchased option contracts to hedge these anticipated transactions. These contracts generally mature in six months or less.
- Although these contracts are intended to economically hedge foreign currency risks to the extent possible, the differences between the contract terms of our derivatives and the underlying forecasted exposures have limited our ability to obtain hedge accounting for all such derivatives. Accordingly, changes in value for a majority of these derivatives were recorded directly through earnings. However, during 2007 we started to designate certain contracts hedging our foreign currency denominated inventory purchases as cash-flow hedges – see “Cash Flow Hedges” below for additional information.
During 2007, 2006, and 2005, we recorded net currency losses of $8, $39 and $5, respectively. Net currency losses primarily result from the mark-to-market of foreign exchange contracts utilized to hedge foreign currency denominated assets and liabilities, the cost of hedging foreign currency-denominated assets and liabilities, the re-measurement of foreign currency-denominated assets and liabilities and the mark-to-market impact of economic hedges of anticipated transactions for which we do not apply cash flow hedge accounting treatment.
At December 31, 2007, we had outstanding forward exchange and purchased option contracts with gross notional values of $2,085. The following is a summary of the primary hedging positions and corresponding fair values held as of December 31, 2007:
| Currency Hedged (Buy/Sell) (in millions) |
Gross
Notional Value |
Fair Value
Asset (Liability) |
|||||
|
U.K. Pound Sterling/Euro |
$ | 534 | $ | (12 | ) | ||
|
Euro/U.S. Dollar |
439 | 24 | |||||
|
U.S. Dollar/Euro |
222 | (7 | ) | ||||
|
Swedish Kronor/Euro |
180 | (5 | ) | ||||
|
Swiss Franc/Euro |
156 | 1 | |||||
|
Japanese Yen/U.S. Dollar |
132 | (1 | ) | ||||
|
Japanese Yen/Euro |
126 | (2 | ) | ||||
|
Euro/U.K. Pound Sterling |
39 | 1 | |||||
|
U.S. Dollar/Canadian Dollar |
15 | – | |||||
|
Canadian Dollar/Euro |
3 | – | |||||
|
All Other |
239 | (2 | ) | ||||
|
Total |
$ | 2,085 | $ | (3 | ) | ||
At December 31, 2006, we had outstanding Japanese Yen/USD cross-currency interest rate swap agreements with aggregate notional amounts of $126 and a net liability fair value of $9. These contracts matured during 2007 together with the scheduled repayment of the related debt. No such contracts were outstanding at December 31, 2007.
Cash Flow Hedges:
Debt related: As of December 31, 2006, our cross currency interest rate swaps were used to hedge the currency exposure for interest payments and principal on half of our Japanese Yen denominated debt of ¥30 billion (U.S. $252). In addition, certain forward currency contracts were used to hedge the currency exposure for interest payments on the remaining Yen debt. These combined strategies converted the hedged cash flows on our Japanese Yen denominated debt to U.S. dollars and qualified for cash flow hedge accounting. The derivatives matured during 2007 together with the scheduled repayment of the related debt.
No amount of ineffectiveness was recorded in the Consolidated Statements of Income for the three years ended December 31, 2007 for these designated cash flow hedges and all components of each derivative’s gain or loss was included in the assessment of hedge effectiveness.
Inventory purchases: During 2007 we began to designate some of our foreign currency derivative contracts as cash flow hedges for a portion of our foreign currency denominated inventory purchases. The changes in fair value for these contracts were reported in AOCL and reclassified to Cost of Sales in the period or periods during which the related inventory was sold. No amount of ineffectiveness was recorded in the Consolidated Statements of Income for these designated cash flow hedges and all components of each derivative’s gain or loss was included in the assessment of hedge effectiveness. As of December 31, 2007, there were no contracts outstanding.
Accumulated Other Comprehensive Loss (“AOCL”): The following table provides a summary of the activity associated with all of our designated cash flow hedges (interest rate and foreign currency) reflected in AOCL for the three years ended December 31, 2007:
| Years ended December 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
|
Net Gain/(Loss): |
||||||||||||
|
Beginning balance, net of tax |
$ | 1 | $ | 1 | $ | 3 | ||||||
|
Changes in fair value |
4 | (1 | ) | (32 | ) | |||||||
|
Reclass to earnings |
(5 | ) | 1 | 30 | ||||||||
|
Ending balance, net of tax |
$ | – | $ | 1 | $ | 1 | ||||||
Fair Value of Financial Instruments: The estimated fair values of our financial instruments at December 31, 2007 and 2006 were as follows:
| 2007 | 2006 | |||||||||||
| (in millions) |
Carrying
Amount |
Fair
Value |
Carrying
Amount |
Fair
Value |
||||||||
|
Cash and cash equivalents |
$ | 1,099 | $ | 1,099 | $ | 1,399 | $ | 1,399 | ||||
|
Short-term investments |
– | – | 137 | 137 | ||||||||
|
Accounts receivable, net |
2,457 | 2,457 | 2,199 | 2,199 | ||||||||
|
Short-term debt |
525 | 525 | 1,485 | 1,487 | ||||||||
|
Long-term debt |
6,939 | 7,176 | 5,660 | 5,917 | ||||||||
|
Liability to subsidiary trust issuing preferred securities |
632 | 632 | 624 | 640 | ||||||||
The fair value amounts for Cash and cash equivalents and Accounts receivable, net approximate carrying amounts due to the short maturities of these instruments. The fair value of Short and Long-term debt, as well as our Liability to subsidiary trust issuing preferred securities, was estimated based on quoted market prices for publicly traded securities or on the current rates offered to us for debt of similar maturities. The difference between the fair value and the carrying value represents the theoretical net premium or discount we would pay or receive to retire all debt at such date.
