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116 The External Users of Accounting Information

is required for financial instruments such as accounts and notes receivable and
payable, investment securities, options, future contracts, and interest rate swaps.41
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, “Accounting for Derivative Instruments and Hedging Activities,” which su-
persedes SFAS No. 105 and 119 and amends SFAS No. 107. In summary, this new
accounting standard requires that:

• All derivatives must be measured at fair value and recognized in the balance
sheet as assets or liabilities.
• With the exception for derivatives that qualify as hedges (fair value hedge,
cash-flow hedge, and foreign currency hedge), changes in the fair value of de-
rivatives must be recognized in income.
With respect to derivatives that qualify as hedges, management may elect to
use hedge accounting to defer gains or losses; however, it should be noted that
the deferral of such gains or losses depends on the effectiveness of the deriva-
tive in offsetting changes in the fair value of the hedged item or changes in fu-
ture cash flows. In addition, the changes in the fair value of asset, liability, or
firm commitment being hedged must be recognized in income to the extent of
offsetting gains or losses on the hedged instrument.42

The use of market value accounting and the estimate of fair values may cause
positive or negative variability in income because of changes in the market values
and inaccurate estimates of fair values of financial instruments.
The 2002 annual report of a publicly held bank and the 2003 annual report of
the largest retailer included the following footnote disclosures.

Financial Instruments
In the normal course of business, the Company is a party to certain financial instru-
ments with off-balance-sheet risk, such as commitments to extend credit, unused
lines of credit and standby letters of credit. The Company™s policy is to record such
instruments when funded.
Fair Value of Financial Instruments
The following methods and assumptions were used by the company in estimating its
fair values for financial instruments for purposes of disclosure:
Cash and cash equivalents and accrued interest receivable/payable: The car-
rying amounts reported in the consolidated statements of condition for these
instruments approximate fair value.

Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 107, “Dis-
closures About Fair Value of Financial Instruments” (Norwalk, CT.: FASB, 1991). In October 1994,
the FASB issued SFAS No. 119, “Disclosure about Derivative Financial Instruments and Fair Value
Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 133, “Ac-
counting for Derivatives Instruments and Hedging Activities” (Norwalk, CT.: FASB, 1998). With re-
spect to the different types of hedges, disclosure, and transition requirements, see SFAS No. 133. This
statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Also see
SFAS Nos. 138, 149, and 150 for amendments.
Credit Grantors 117

Investment securities and FHLB stock: Fair values for investment securities
are based on quoted market prices or dealer quotes. The fair value of FHLB
stock is assumed to equal the carrying value since the stock is non-marketable
but redeemable at its par value.
Loans and loans held for sale: Fair values for loans are estimated using a dis-
counted cash flow analysis, based on interest rates approximating those cur-
rently being offered for loans with similar terms and credit quality.
Deposits: The fair values disclosed for non-interest-bearing accounts and ac-
counts with no stated maturities are, by definition, equal to the amount
payable on demand at the reporting date. The fair value of time deposits was
estimated by discounting expected monthly maturities at interest rates ap-
proximating those currently being offered on time deposits of similar terms.
Borrowings and trust preferred securities: the carrying amounts of repurchase
agreements and FHLB line of credit advances approximate fair value. Fair
values for FHLB term advances, other borrowings and trust preferred securi-
ties are estimated using discounted cash flows, based on current market rates
for similar borrowings.
Off-balance-sheet instruments: Off-balance-sheet financial instruments consist
of letters of credit and commitments to extend credit. Letters of credit and com-
mitments to extend credit are fair valued based on fees and interest rates cur-
rently charged to enter into agreements with similar terms and credit quality.

Note 10: Derivative Financial Instruments
The Company has used interest rate swap agreements (“swaps”) from time to time
as a part of its overall interest rate risk management strategy. At December 31, 2002,
and during the year then ended, the Company had no swaps outstanding. In 2001 and
2000, the swaps modified the repricing characteristics of certain brokered time de-
posit liabilities. Under the terms of the swaps, the Company received a fixed rate of
interest and paid a variable rate of interest. He swaps were entered into with a coun-
terparty that met the Company™s established credit standards and the agreements
contained collateral provisions protecting the at-risk party. The company considered
the credit risk inherent in these contracts to be negligible. The swaps matched the re-
lated brokered time deposits in notional/face amount, fixed interest rate, interest
payment date and maturity date.
Effective January 1, 2001, the Company adopted SFAS No. 133, “Accounting for
Derivative Instruments and Hedging Activities.” Under SFAS No. 133, the swaps
were accounted for as fair value hedges of the brokered time deposit liabilities. The
swaps and the brokered time deposits were recorded at fair value on the consolidated
statement of condition. The adoption of SFAS No. 133 had no material impact on net
income or shareholders™ equity.43
Financial Instruments
The company uses derivative financial instruments for hedging and non-trading pur-
poses to manage its exposure to interest and foreign exchange rates. Use of deriva-
tive financial instruments in hedging programs subjects the Company to certain risks,
such as market and credit risks. Market risk represents the possibility that the value
of the derivative instrument will change. In a hedging relationship, the change in the
value of the derivative is offset to a great extent by the change in the value of the

BSB Bancorp, Inc., 2002 Annual Report, pp. 32, 39.
118 The External Users of Accounting Information

underlying hedged item. Credit risk related to derivatives represents the possibility
that the counterparty will not fulfill the terms of the contract. Credit risk is monitored
through established approval procedures, including setting concentration limits by
counterparty, reviewing credit ratings and requiring collateral (generally cash) when
appropriate. The majority of the Company™s transactions are with counterparties
rated A or better by nationally recognized credit rating agencies.
Adoption of FASB 133
On February 1, 2001, the Company adopted Financial Accounting Standards Board
Statement No. 133, “Accounting for Derivative and Hedging Activities” (FAS 133)
as amended. Because most of the derivatives used by the company at the date of
adoption were designated as net investment hedges, the fair value of these instru-
ments was included in the balance sheet prior to adoption of the standard. As a result,
the adoption of this standard did not have a significant effect on the consolidation fi-
nancial statements of the Company.
Fair Value Instruments
The Company enters into interest rate swaps to minimize the risks and costs associ-
ated with its financing activities. Under the swap agreements, the company pays vari-
able rate interest and receives fixed interest rate payments periodically over the life of
the instruments. The notional amounts are used to measure interest to be paid or re-
ceived and do not represent the exposure due to credit loss. All of the Company™s in-
terest rate swaps are designated as fair value hedges. In a fair value hedge, the gain or
loss on the derivative instrument as well as the offsetting gain or loss on the hedged
item attributable to the hedged risk are recognized in earnings in the current period.
Ineffectiveness results when gains and losses on the hedged item are not completely
offset by gains and losses in the hedged instrument. No ineffectiveness was recog-
nized in fiscal 2003 related to these instruments. The fair value of these contracts is
included in the balance sheet in the line titled “Other assets and deferred charges.”
Net Investment Instruments
At January 31, 2003, the company is a party to cross-currency interest rate swaps that
hedge its net investment in the United Kingdom. The agreements are contracts to
exchange fixed rate payments in one currency for fixed rate payments in another cur-
rency. The Company also holds approximately GBP 1 billion of debt that is desig-
nated as hedges of net investment.
During the fourth quarter of fiscal 2002, the Company terminated or sold cross-
country instruments that hedged portions of the Company™s investments in Canada,
Germany and the United Kingdom. These instruments had notional amounts of $6.7
billion. The Company received $1.1 billion in cash related to the fair value of the in-
struments at the time of the terminations. Prior to the terminations, these instru-
ments were classified as net investment hedges and had been recorded at fair value
as current assets on the balance sheet with a like amount recorded on the balance
sheet shareholders™ equity section in the line “other accumulated comprehensive in-
come.” No gain related to the terminations was recorded in the Company™s income
statement. The fair value of these contracts is included in the balance sheet in the line
titled “Other assets and deferred charges.”
Cash Flow Hedge
The Company entered into a cross-currency interest rate swap to hedge the foreign
currency risk of certain yen denominated intercompany debt. The company has en-
Credit Grantors 119

tered into a cross-currency interest rate swap related to U.S. dollar denominated debt
securities issued by a Canadian subsidiary of the Company. These swaps are desig-
nated as cash flow hedges of foreign currency exchange risk. No ineffectiveness was
recognized during fiscal 2003 related to these instruments. The Company expects that
the amount of gain existing in other comprehensive income that is expected to be re-
classified into earnings within the next 12 months will not be significant. Changes in
the foreign currency spot exchange rate result in reclassification of amounts from
other comprehensive income to earnings to offset transaction gains or losses on for-
eign denominated debt. The fair value of these hedges are included in the balance
sheet in the line titled “Other assets and deferred charges.”

Instrument Not Designated for Hedging
The Company enters into forward currency exchange contracts in the regular course
of business to manage its exposure against foreign currency fluctuations on cross-
border purchases of inventory. These contracts are generally for short durations of six
months or less. Although these instruments are economic hedges, the Company did
not designate these contracts as hedges as required in order to obtain hedge ac-
counting. As a result, the Company marks the contracts to market through earnings.
The fair value of these contracts is included in the balance sheet in the line titled
“Prepaid expenses and other.”

Fair Value of Financial Instruments

Notional Amount Fair Value
(amounts in millions) 1/31/2003 1/31/2002 1/31/2003 1/31/2002

Derivative financial instruments
designated for hedging:

Receive fixed rate, pay floating
rate interest rate swaps
designated as fair value hedges $8,292 $3,792 $803 $172

Receive fixed rate, pay fixed rate
cross-currency interest rate
swaps designated as net invest-
ment hedges (FX notional
amount: GBP 795 at 1/31/2003
and 2002) 1,250 1,250 126 192

Receive fixed rate, pay fixed rate
cross-currency interest rate swap
designated as cash flow hedge
(FX notional amount: CAD 503
at 1/31/2003 and 2002) 325 325 8 8

Receive fixed rate, pay fixed rate
cross-currency interest rate swap
designated as cash flow hedge
(FX notional amount: JPY
52,056 at 1/31/2003 and 2002) 432 ” 2 ”
““““““ ““““““ ““““““ ““““““
10,299 5,367 939 372
120 The External Users of Accounting Information

Notional Amount Fair Value
(amounts in millions) 1/31/2003 1/31/2002 1/31/2003 1/31/2002
Derivative financial instruments
not designated for hedging:
Foreign currency exchange
forward contracts (various
currencies) 185 117 ” ”
Basis swap 500 500 2 1
““““““ ““““““ ““““““ ““““““
685 617 2 1
Non-derivative financial
““““““ ““““““ ““““““ ““““““
Long-term debt 21,145 17,944 20,464 18,919
Cash and cash equivalents: The carrying amount approximates fair value due to the
short maturity of these instruments.
Long term debt: Fair value is based on the Company™s current incremental borrow-
ing rate for similar types of borrowing arrangements.
Interest rate instruments and net investment instruments: The fair values are esti-
mated amounts the company would receive or pay to terminate the agreements as of
the reporting dates.
Foreign currency contracts: The fair value of foreign currency contracts are esti-
mated by obtaining quotes from external sources.44

Importance of Regulatory Agencies
In a private enterprise economy, the corporation is a productive resource whereby
corporate management is engaged in the ultimate economic decisions regarding
the use of the enterprise™s economic resources. Such economic decisions are in-
fluenced by the various regulatory agencies, such as the Securities and Exchange
Commission (SEC) and the Federal Trade Commission (FTC), so that manage-
ment is not totally independent. Moreover, regulatory agencies provide a compre-
hensive set of rules and regulations in order to control the enterprise as well as to
safeguard the interests of investors and the general public. For example, the ob-
jective of the Federal Trade Commission is to prevent monopolistic practices and
price discrimination in American industry. Also, several commissions supervise
certain industries, such as the utility and transportation industries, as well as the
area of labor-management relations. Particularly important is the government™s
regulation of the securities market and the taxation process. Such regulation is es-
sential to the economy to eliminate financial abuses and unfair practices in the pri-
vate sector. Thus the audit committee should be concerned with the reporting
requirements of the governmental regulatory agencies.

Wal-Mart Stores, Inc., 2003 Annual Report, pp. 40“42.
Regulatory Agencies 121

The Need for Accounting Information
In order to formulate sound public policies, the regulatory commissions need ac-
counting information concerning the economic activities of the enterprise. In ad-
dition, they need accounting information to monitor the corporation™s compliance


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