Quarterly report pursuant to Section 13 or 15(d)

Hedging Transactions and Derivative Financial Instruments

v3.3.0.814
Hedging Transactions and Derivative Financial Instruments
 9 Months Ended
Oct. 02, 2015
Hedging Transactions and Derivative Financial Instruments  
Hedging Transactions and Derivative Financial Instruments
HEDGING TRANSACTIONS AND DERIVATIVE FINANCIAL INSTRUMENTS
The Company is directly and indirectly affected by changes in certain market conditions. These changes in market conditions may adversely impact the Company's financial performance and are referred to as "market risks." When deemed appropriate, our Company uses derivatives as a risk management tool to mitigate the potential impact of certain market risks. The primary market risks managed by the Company through the use of derivative and non-derivative financial instruments are foreign currency exchange rate risk, commodity price risk and interest rate risk.
The Company uses various types of derivative instruments including, but not limited to, forward contracts, commodity futures contracts, option contracts, collars and swaps. Forward contracts and commodity futures contracts are agreements to buy or sell a quantity of a currency or commodity at a predetermined future date, and at a predetermined rate or price. An option contract is an agreement that conveys the purchaser the right, but not the obligation, to buy or sell a quantity of a currency or commodity at a predetermined rate or price during a period or at a time in the future. A collar is a strategy that uses a combination of options to limit the range of possible positive or negative returns on an underlying asset or liability to a specific range, or to protect expected future cash flows. To do this, an investor simultaneously buys a put option and sells (writes) a call option, or alternatively buys a call option and sells (writes) a put option. A swap agreement is a contract between two parties to exchange cash flows based on specified underlying notional amounts, assets and/or indices. We do not enter into derivative financial instruments for trading purposes. The Company may also designate certain non-derivative instruments, such as our foreign-denominated debt, in hedging relationships.
All derivative instruments are carried at fair value in our condensed consolidated balance sheets in the following line items, as applicable: prepaid expenses and other assets; other assets; accounts payable and accrued expenses; and other liabilities. The carrying values of the derivative instruments reflect the impact of legally enforceable master netting agreements and cash collateral held or placed with the same counterparties, as applicable. These master netting agreements allow the Company to net settle positive and negative positions (assets and liabilities) arising from different transactions with the same counterparty.
The accounting for gains and losses that result from changes in the fair values of derivative instruments depends on whether the derivatives have been designated and qualify as hedging instruments and the type of hedging relationships. Derivatives can be designated as fair value hedges, cash flow hedges or hedges of net investments in foreign operations. The changes in the fair values of derivatives that have been designated and qualify for fair value hedge accounting are recorded in the same line item in our condensed consolidated statements of income as the changes in the fair values of the hedged items attributable to the risk being hedged. The changes in the fair values of derivatives that have been designated and qualify as cash flow hedges or hedges of net investments in foreign operations are recorded in AOCI and are reclassified into the line item in our condensed consolidated statement of income in which the hedged items are recorded in the same period the hedged items affect earnings. Due to the high degree of effectiveness between the hedging instruments and the underlying exposures being hedged, fluctuations in the values of the derivative instruments are generally offset by changes in the fair values or cash flows of the underlying exposures being hedged. The changes in fair values of derivatives that were not designated and/or did not qualify as hedging instruments are immediately recognized into earnings.
For derivatives that will be accounted for as hedging instruments, the Company formally designates and documents, at inception, the financial instrument as a hedge of a specific underlying exposure, the risk management objective and the strategy for undertaking the hedge transaction. In addition, the Company formally assesses, both at inception and at least quarterly thereafter, whether the financial instruments used in hedging transactions are effective at offsetting changes in either the fair values or cash flows of the related underlying exposures. Any ineffective portion of a financial instrument's change in fair value is immediately recognized into earnings.
The Company determines the fair values of its derivatives based on quoted market prices or pricing models using current market rates. Refer to Note 14. The notional amounts of the derivative financial instruments do not necessarily represent amounts exchanged by the parties and, therefore, are not a direct measure of our exposure to the financial risks described above. The amounts exchanged are calculated by reference to the notional amounts and by other terms of the derivatives, such as interest rates, foreign currency exchange rates or other financial indices. The Company does not view the fair values of its derivatives in isolation, but rather in relation to the fair values or cash flows of the underlying hedged transactions or other exposures. Virtually all of our derivatives are straightforward over-the-counter instruments with liquid markets.
The following table presents the fair values of the Company's derivative instruments that were designated and qualified as part of a hedging relationship (in millions):
 
 
Fair Value1,2
Derivatives Designated as
Hedging Instruments
Balance Sheet Location1
October 2,
2015

December 31, 2014

Assets:
 
 
 
Foreign currency contracts
Prepaid expenses and other assets
$
644

$
923

Foreign currency contracts
Other assets
443

346

Interest rate contracts
Prepaid expenses and other assets
24

14

Interest rate contracts
Other assets
88

146

Total assets
 
$
1,199

$
1,429

Liabilities:
 
 
 
Foreign currency contracts
Accounts payable and accrued expenses
$
29

$
24

Foreign currency contracts
Other liabilities
44

249

Commodity contracts
Accounts payable and accrued expenses
1

1

Interest rate contracts
Accounts payable and accrued expenses
14

11

Interest rate contracts
Other liabilities
263

35

Total liabilities
 
$
351

$
320

1 All of the Company's derivative instruments are carried at fair value in our condensed consolidated balance sheets after considering the impact of legally enforceable master netting agreements and cash collateral held or placed with the same counterparties, as applicable. Current disclosure requirements mandate that derivatives must also be disclosed without reflecting the impact of master netting agreements and cash collateral. Refer to Note 14 for the net presentation of the Company's derivative instruments.
2 Refer to Note 14 for additional information related to the estimated fair value.
The following table presents the fair values of the Company's derivative instruments that were not designated as hedging instruments (in millions):
 
 
Fair Value1,2
Derivatives Not Designated as
Hedging Instruments
Balance Sheet Location1
October 2,
2015

December 31, 2014

Assets:
 
 
 
Foreign currency contracts
Prepaid expenses and other assets
$
59

$
44

Foreign currency contracts
Other assets
239

231

Commodity contracts
Prepaid expenses and other assets
7

9

Commodity contracts
Other assets
1

1

Other derivative instruments
Prepaid expenses and other assets
2

14

Other derivative instruments
Other assets
—

2

Total assets
 
$
308

$
301

Liabilities:
 
 
 
Foreign currency contracts
Accounts payable and accrued expenses
$
20

$
33

Foreign currency contracts
Other liabilities
2

21

Commodity contracts
Accounts payable and accrued expenses
153

156

Commodity contracts
Other liabilities
31

17

Interest rate contracts
Other liabilities
2

2

Other derivative instruments
Accounts payable and accrued expenses
27

11

Other derivative instruments
Other liabilities
20

—

Total liabilities
 
$
255

$
240

1 All of the Company's derivative instruments are carried at fair value in our condensed consolidated balance sheets after considering the impact of legally enforceable master netting agreements and cash collateral held or placed with the same counterparties, as applicable. Current disclosure requirements mandate that derivatives must also be disclosed without reflecting the impact of master netting agreements and cash collateral. Refer to Note 14 for the net presentation of the Company's derivative instruments.
2 Refer to Note 14 for additional information related to the estimated fair value.
Credit Risk Associated with Derivatives
We have established strict counterparty credit guidelines and enter into transactions only with financial institutions of investment grade or better. We monitor counterparty exposures regularly and review any downgrade in credit rating immediately. If a downgrade in the credit rating of a counterparty were to occur, we have provisions requiring cash collateral in for substantially all of our transactions. To mitigate presettlement risk, minimum credit standards become more stringent as the duration of the derivative financial instrument increases. In addition, the Company's master netting agreements reduce credit risk by permitting the Company to net settle for transactions with the same counterparty. To minimize the concentration of credit risk, we enter into derivative transactions with a portfolio of financial institutions. Based on these factors, we consider the risk of counterparty default to be minimal.
Cash Flow Hedging Strategy
The Company uses cash flow hedges to minimize the variability in cash flows of assets or liabilities or forecasted transactions caused by fluctuations in foreign currency exchange rates, commodity prices or interest rates. The changes in the fair values of derivatives designated as cash flow hedges are recorded in AOCI and are reclassified into the line item in our condensed consolidated statement of income in which the hedged items are recorded in the same period the hedged items affect earnings. The changes in fair values of hedges that are determined to be ineffective are immediately reclassified from AOCI into earnings. The maximum length of time for which the Company hedges its exposure to future cash flows is typically three years.
The Company maintains a foreign currency cash flow hedging program to reduce the risk that our eventual U.S. dollar net cash inflows from sales outside the United States and U.S. dollar net cash outflows from procurement activities will be adversely affected by fluctuations in foreign currency exchange rates. We enter into forward contracts and purchase foreign currency options (principally euros and Japanese yen) and collars to hedge certain portions of forecasted cash flows denominated in foreign currencies. When the U.S. dollar strengthens against the foreign currencies, the decline in the present value of future foreign currency cash flows is partially offset by gains in the fair value of the derivative instruments. Conversely, when the U.S. dollar weakens, the increase in the present value of future foreign currency cash flows is partially offset by losses in the fair value of the derivative instruments. The total notional values of derivatives that were designated and qualified for the Company's foreign currency cash flow hedging program were $11,715 million and $13,224 million as of October 2, 2015 and December 31, 2014, respectively.
The Company uses cross-currency swaps to hedge the changes in cash flows of certain of its foreign currency denominated debt due to changes in foreign currency exchange rates.  For this hedging program, the Company records the change in carrying value of the foreign currency denominated debt due to changes in exchange rates into earnings each period. The changes in fair value of the cross-currency swap derivatives are recorded in AOCI with an immediate reclassification into earnings for the change in fair value attributable to fluctuations in foreign currency exchange rates. These swaps had a notional amount of $2,590 million as of December 31, 2014. During the nine months ended October 2, 2015, the Company discontinued the cash flow hedge relationships related to these swaps. Upon discontinuance, the Company recognized a loss of $92 million in other comprehensive income, which will be reclassified from AOCI into interest expense over the remaining life of the debt, a weighted-average period of approximately 10 years. The Company did not discontinue any cash flow hedging relationships during the nine months ended September 26, 2014. During the nine months ended October 2, 2015, the Company entered into new cross-currency swaps, which had a notional value of $566 million as of October 2, 2015.
The Company has entered into commodity futures contracts and other derivative instruments on various commodities to mitigate the price risk associated with forecasted purchases of materials used in our manufacturing process. These derivative instruments have been designated and qualify as part of the Company's commodity cash flow hedging program. The objective of this hedging program is to reduce the variability of cash flows associated with future purchases of certain commodities. The total notional values of derivatives that were designated and qualified for the Company's commodity cash flow hedging program were $6 million and $9 million as of October 2, 2015 and December 31, 2014, respectively.
Our Company monitors our mix of short-term debt and long-term debt regularly. From time to time, we manage our risk to interest rate fluctuations through the use of derivative financial instruments. The Company has entered into interest rate swap agreements and has designated these instruments as part of the Company's interest rate cash flow hedging program. The objective of this hedging program is to mitigate the risk of adverse changes in benchmark interest rates on the Company's future interest payments. The total notional values of these interest rate swap agreements that were designated and qualified for the Company's interest rate cash flow hedging program were $4,829 million and $4,328 million as of October 2, 2015 and December 31, 2014, respectively.
The following table presents the pretax impact that changes in the fair values of derivatives designated as cash flow hedges had on AOCI and earnings during the three months ended October 2, 2015 (in millions):
 
Gain (Loss) Recognized
in Other Comprehensive Income ("OCI")

Location of Gain (Loss)
Recognized in Income1
Gain (Loss)
Reclassified from
AOCI into Income
(Effective Portion)

Gain (Loss) Recognized in Income (Ineffective Portion and Amount Excluded from Effectiveness Testing)

 
Foreign currency contracts
$
1

Net operating revenues
$
170

$
—

2 
Foreign currency contracts
22

Cost of goods sold
16

—

2 
Foreign currency contracts
—

Interest expense
(3
)
—

 
Interest rate contracts
(223
)
Interest expense
1

(3
)
 
Commodity contracts
(1
)
Cost of goods sold
(1
)
—

 
Total
$
(201
)
 
$
183

$
(3
)
 
1 The Company records gains and losses reclassified from AOCI into income for the effective portion and the ineffective portion, if any, to the same line items in our condensed consolidated statements of income.
2 Includes a de minimis amount of ineffectiveness in the hedging relationship.
The following table presents the pretax impact that changes in the fair values of derivatives designated as cash flow hedges had on AOCI and earnings during the nine months ended October 2, 2015 (in millions):
 
Gain (Loss) Recognized
in OCI

Location of Gain (Loss)
Recognized in Income1
Gain (Loss)
Reclassified from
AOCI into Income
(Effective Portion)

Gain (Loss) Recognized in Income (Ineffective Portion and Amount Excluded from Effectiveness Testing)

 
Foreign currency contracts
$
727

Net operating revenues
$
468

$
—

2 
Foreign currency contracts
52

Cost of goods sold
44

—

2 
Foreign currency contracts
18

Interest expense
(7
)
—

 
Interest rate contracts
(187
)
Interest expense
(2
)
(3
)
 
Commodity contracts
(2
)
Cost of goods sold
(2
)
—

 
Total
$
608

 
$
501

$
(3
)
 
1 The Company records gains and losses reclassified from AOCI into income for the effective portion and the ineffective portion, if any, to the same line items in our condensed consolidated statements of income.
2 Includes a de minimis amount of ineffectiveness in the hedging relationship.
The following table presents the pretax impact that changes in the fair values of derivatives designated as cash flow hedges had on AOCI and earnings during the three months ended September 26, 2014 (in millions):
 
Gain (Loss)
Recognized
in OCI

Location of Gain (Loss)
Recognized in Income1
Gain (Loss)
Reclassified from
AOCI into Income
(Effective Portion)

Gain (Loss)
Recognized in Income
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)

 
Foreign currency contracts
$
490

Net operating revenues
$
19

$
—

 
Foreign currency contracts
36

Cost of goods sold
5

—

2 
Foreign currency contracts
(93
)
Other income (loss) — net
(52
)
—

 
Interest rate contracts
(9
)
Interest expense
—

—

 
Commodity contracts
—

Cost of goods sold
1

—

 
Total
$
424

 
$
(27
)
$
—

 
1 The Company records gains and losses reclassified from AOCI into income for the effective portion and the ineffective portion, if any, to the same line items in our condensed consolidated statements of income.
2 Includes a de minimis amount of ineffectiveness in the hedging relationship.
The following table presents the pretax impact that changes in the fair values of derivatives designated as cash flow hedges had on AOCI and earnings during the nine months ended September 26, 2014 (in millions):
 
Gain (Loss)
Recognized
in OCI

Location of Gain (Loss)
Recognized in Income1
Gain (Loss)
Reclassified from
AOCI into Income
(Effective Portion)

Gain (Loss)
Recognized in Income
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)

 
Foreign currency contracts
$
378

Net operating revenues
$
62

$
—

2 
Foreign currency contracts
15

Cost of goods sold
25

—

2 
Foreign currency contracts
(93
)
Other income (loss) — net
(52
)
—

 
Interest rate contracts
(100
)
Interest expense
—

—

 
Commodity contracts
1

Cost of goods sold
2

—

 
Total
$
201

 
$
37

$
—

 
1 The Company records gains and losses reclassified from AOCI into income for the effective portion and the ineffective portion, if any, to the same line items in our condensed consolidated statements of income.
2 Includes a de minimis amount of ineffectiveness in the hedging relationship.
As of October 2, 2015, the Company estimates that it will reclassify into earnings during the next 12 months $618 million of gains from the pretax amount recorded in AOCI as the anticipated cash flows occur.
Fair Value Hedging Strategy
The Company uses interest rate swap agreements designated as fair value hedges to minimize exposure to changes in the fair value of fixed-rate debt that results from fluctuations in benchmark interest rates. The Company also uses cross-currency interest rate swaps to hedge the changes in the fair value of foreign currency denominated debt relating to changes in foreign currency exchange rates and benchmark interest rates. The changes in fair values of derivatives designated as fair value hedges and the offsetting changes in fair values of the hedged items are recognized in earnings. The ineffective portions of these hedges are immediately recognized in earnings. As of October 2, 2015, such adjustments had cumulatively increased the carrying value of our long-term debt by $20 million. When a derivative is no longer designated as a fair value hedge for any reason, including termination and maturity, the remaining unamortized difference between the carrying value of the hedged item at that time and the par value of the hedged item is amortized to earnings over the remaining life of the hedged item, or immediately if the hedged item has matured. The total notional values of derivatives that related to our fair value hedges of this type were $9,147 million and $6,600 million as of October 2, 2015 and December 31, 2014, respectively.
The Company also uses fair value hedges to minimize exposure to changes in the fair value of certain available-for-sale securities from fluctuations in foreign currency exchange rates. The changes in fair values of derivatives designated as fair value hedges and the offsetting changes in fair values of the hedged items are recognized in earnings. As a result, any difference is reflected in earnings as ineffectiveness. The total notional values of derivatives that related to our fair value hedges of this type were $1,479 million and $1,358 million as of October 2, 2015 and December 31, 2014, respectively.
The following table summarizes the pretax impact that changes in the fair values of derivatives designated as fair value hedges had on earnings during the three months ended October 2, 2015 and September 26, 2014 (in millions):
Hedging Instruments and Hedged Items
Location of Gain (Loss)
Recognized in Income
Gain (Loss)
Recognized in Income 1
Three Months Ended
October 2,
2015

September 26,
2014

Interest rate contracts
Interest expense
$
151

$
(36
)
Fixed-rate debt
Interest expense
(152
)
44

Net impact to interest expense
 
$
(1
)
$
8

Foreign currency contracts
Other income (loss) — net
$
82

$
12

Available-for-sale securities
Other income (loss) — net
(87
)
(18
)
Net impact to other income (loss) — net

$
(5
)
$
(6
)
Net impact of fair value hedging instruments

$
(6
)
$
2

1 The net impacts represent the ineffective portions of the hedge relationships and the amounts excluded from the assessment of hedge effectiveness.
The following table summarizes the pretax impact that changes in the fair values of derivatives designated as fair value hedges had on earnings during the nine months ended October 2, 2015 and September 26, 2014 (in millions):
Hedging Instruments and Hedged Items
Location of Gain (Loss)
Recognized in Income
Gain (Loss)
Recognized in Income 1
Nine Months Ended
October 2,
2015

September 26,
2014

Interest rate contracts
Interest expense
$
(71
)
$
(10
)
Fixed-rate debt
Interest expense
79

29

Net impact to interest expense
 
$
8

$
19

Foreign currency contracts
Other income (loss) — net
$
217

$
(7
)
Available-for-sale securities
Other income (loss) — net
(231
)
(10
)
Net impact to other income (loss) — net

$
(14
)
$
(17
)
Net impact of fair value hedging instruments

$
(6
)
$
2

1 The net impacts represent the ineffective portions of the hedge relationships and the amounts excluded from the assessment of hedge effectiveness.
Hedges of Net Investments in Foreign Operations Strategy
The Company uses forward contracts and non-derivative financial instruments to protect the value of our investments in a number of foreign subsidiaries. During the nine months ended October 2, 2015, the Company designated a portion of its euro-denominated debt as a hedge of a net investment in our European operations. The change in the carrying value of the designated portion of the euro-denominated debt due to changes in exchange rates is recorded in net foreign currency translation adjustment, a component of AOCI. For derivative instruments that are designated and qualify as hedges of net investments in foreign operations, the changes in fair values of the derivative instruments are recognized in net foreign currency translation adjustment, to offset the changes in the values of the net investments being hedged. Any ineffective portions of net investment hedges are reclassified from AOCI into earnings during the period of change.
The following table summarizes the notional values and pretax impact of changes in the fair values of instruments designated as net investment hedges (in millions):
 
Notional Amount
 
Gain (Loss) Recognized in OCI
 
as of
 
Three Months Ended
 
Nine Months Ended
 
October 2,
2015

December 31,
2014

 
October 2,
2015

September 26,
2014

 
October 2,
2015

September 26,
2014

Foreign currency contracts
$
1,657

$
2,047

 
$
274

$
134

 
$
680

$
(8
)
Foreign currency denominated debt
11,420

—

 
(104
)
—

 
(386
)
—

Total
$
13,077

$
2,047

 
$
170

$
134

 
$
294

$
(8
)

The Company did not reclassify any deferred gains or losses related to net investment hedges from AOCI into earnings during the three and nine months ended October 2, 2015 and September 26, 2014. In addition, the Company did not have any ineffectiveness related to net investment hedges during the three and nine months ended October 2, 2015 and September 26, 2014. The cash inflows and outflows associated with the Company's derivative contracts designated as net investment hedges are classified in the line item other investing activities in our condensed consolidated statements of cash flows.
Economic (Nondesignated) Hedging Strategy
In addition to derivative instruments that are designated and qualify for hedge accounting, the Company also uses certain derivatives as economic hedges to primarily manage foreign currency, interest rate and commodity exposure. Although these derivatives were not designated and/or did not qualify for hedge accounting, they are effective economic hedges. The changes in fair values of economic hedges are immediately recognized into earnings.
The Company uses foreign currency economic hedges to offset the earnings impact that fluctuations in foreign currency exchange rates have on certain monetary assets and liabilities denominated in nonfunctional currencies. The changes in fair values of economic hedges used to offset those monetary assets and liabilities are immediately recognized into earnings in the line item other income (loss) — net in our condensed consolidated statements of income. In addition, we use foreign currency economic hedges to minimize the variability in cash flows associated with fluctuations in foreign currency exchange rates. The changes in fair values of economic hedges used to offset the variability in U.S. dollar net cash flows are recognized into earnings in the line items net operating revenues or cost of goods sold in our condensed consolidated statements of income, as applicable. The total notional values of derivatives related to our foreign currency economic hedges were $4,228 million and $4,334 million as of October 2, 2015 and December 31, 2014, respectively.
The Company also uses certain derivatives as economic hedges to mitigate the price risk associated with the purchase of materials used in the manufacturing process and for vehicle fuel. The changes in fair values of these economic hedges are immediately recognized into earnings in the line items net operating revenues, cost of goods sold, and selling, general and administrative expenses in our condensed consolidated statements of income, as applicable. The total notional values of derivatives related to our economic hedges of this type were $1,212 million and $816 million as of October 2, 2015 and December 31, 2014, respectively.
The following tables present the pretax impact that changes in the fair values of derivatives not designated as hedging instruments had on earnings (in millions):
 
 
Three Months Ended
Derivatives Not Designated
as Hedging Instruments
Location of Gain (Loss)
Recognized in Income
October 2,
2015

September 26,
2014

Foreign currency contracts
Net operating revenues
$
34

$
6

Foreign currency contracts
Other income (loss) — net
(26
)
(70
)
Foreign currency contracts
Cost of goods sold
2

—

Commodity contracts
Net operating revenues
(9
)
(9
)
Commodity contracts
Cost of goods sold
(133
)
25

Commodity contracts
Selling, general and administrative expenses
(14
)
(15
)
Other derivative instruments
Selling, general and administrative expenses
(12
)
3

Other derivative instruments
Other income (loss) — net
(24
)
18

Total
 
$
(182
)
$
(42
)

 
 
Nine Months Ended
Derivatives Not Designated
as Hedging Instruments
Location of Gain (Loss)
Recognized in Income
October 2,
2015

September 26,
2014

Foreign currency contracts
Net operating revenues
$
43

$
(12
)
Foreign currency contracts
Other income (loss) — net
(75
)
(47
)
Foreign currency contracts
Cost of goods sold
3

—

Commodity contracts
Net operating revenues
(8
)
(9
)
Commodity contracts
Cost of goods sold
(152
)
60

Commodity contracts
Selling, general and administrative expenses
(13
)
(14
)
Other derivative instruments
Selling, general and administrative expenses
(11
)
17

Other derivative instruments
Other income (loss) — net
(86
)
26

Total
 
$
(299
)
$
21