American Express 2006 Annual Report Download - page 82

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notes to consolidated fi nancial statements
american express company
date. The reserve for Membership Rewards is estimated
using models that analyze historical redemption statistics
and reflect, to a lesser extent, management’s judgment
regarding overall adequacy. The provision for the cost of
Membership Rewards, which is included in marketing,
promotion, rewards and cardmember services, is based
upon points earned that are expected to ultimately be
redeemed by cardmembers and the current weighted-
average cost per point of redemption. The estimated points
to be redeemed are based on many factors, including
past redemption behavior of cardmembers, card product
type, year of program enrollment, and card spend level.
The weighted-average cost per point is affected by the
mix of rewards redeemed. The Company continually
evaluates its reserve methodology and assumptions based
on developments in redemption patterns, cost per point
redeemed, and other factors. During 2006, management
revised the ultimate redemption rate assumption to
reflect program redemption statistics of cardmembers
who left the program in the previous five years, rather
than redemption statistics of the entire population of
cardmembers who left the program since inception.
Management believes that using recent redemption
statistics is a better indicator of future redemption
behavior of active cardmembers.
The liability for Membership Rewards was
approximately $3.8 billion and $3.1 billion at
December 31, 2006 and 2005, respectively, and is
included in other liabilities.
Derivative financial instruments and hedging activities
SFAS No. 133, “Accounting for Derivative Instruments
and Hedging Activities” (SFAS No. 133), as amended,
requires recognition of all derivatives on balance sheet
at fair value as either assets or liabilities. The fair value
of the Company’s derivative financial instruments are
determined using either market quotes or valuation
models that are based upon the net present value of
estimated future cash flows and incorporate current
market data inputs. The Company reports its derivative
assets and liabilities in other assets and other liabilities,
respectively, on a net by counterparty basis where
management believes it has the legal right of offset under
enforceable netting arrangements. The accounting for
the change in the fair value of a derivative financial
instrument depends on its intended use and the resulting
hedge designation, if any, as discussed below.
Cash flow hedges
A cash flow hedge is a derivative designated to hedge the
exposure of variable future cash flows that is attributable
to a particular risk associated with an existing recognized
asset or liability, or a forecasted transaction. For derivative
financial instruments that qualify as cash flow hedges,
the effective portions of the gain or loss on the derivatives
are recorded in accumulated other comprehensive (loss)
income and reclassified into earnings when the hedged
item or transactions impact earnings. The amount that is
reclassified into earnings is presented in the Consolidated
Statements of Income with the hedged instrument or
transaction impact, generally, in net other investment
and interest income or interest expense. Any ineffective
portion of the gain or loss, as determined by the accounting
requirements, is reported as a component of other revenue.
If a hedge is de-designated or terminated prior to maturity,
the amount previously recorded in accumulated other
comprehensive (loss) income is recognized into earnings
over the period that the hedged item impacts earnings. If
a hedge relationship is discontinued because it is probable
that the forecasted transaction will not occur according
to the original strategy, any related amounts previously
recorded in accumulated other comprehensive (loss)
income are recognized into earnings immediately.
Fair value hedges
A fair value hedge is a derivative designated to hedge the
exposure of future changes in the fair value of an asset or
liability, or an identified portion thereof that is attributable
to a particular risk. For derivative financial instruments
that qualify as fair value hedges, changes in the fair value
of the derivatives, as well as of the corresponding hedged
assets, liabilities or firm commitments, are recorded in
earnings as a component of other revenue. If a fair value
hedge is de-designated or terminated prior to maturity,
previous adjustments to the carrying value of the hedged
item are recognized into earnings to match the earnings
pattern of the hedged item.
Net investment hedges in foreign operations
A net investment hedge in foreign operations is a derivative
used to hedge future changes in currency exposure of
a net investment in a foreign operation. For derivative
financial instruments that qualify as net investment
hedges in foreign operations, the effective portions of
the change in fair value of the derivatives are recorded in
accumulated other comprehensive (loss) income as part
of the cumulative translation adjustment. Any ineffective
portions of net investment hedges are recognized in other
revenue during the period of change.
Non-designated derivatives and trading activities
For derivative financial instruments that do not qualify
for hedge accounting, are not designated as hedges, or
consist of customer or proprietary trading activities,
changes in fair value are reported in current period
earnings generally as a component of other revenue,