Microsoft 2004 Annual Report Download - page 41

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NOTES TO FINANCIAL STATEMENTS (CONTINUED)
PAGE 41
measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the
derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is
recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the
risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s
gain or loss is initially reported as a component of OCI and subsequently reclassified into earnings when the hedged
exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated
either as fair-value or cash-flow hedges, changes in the time value are excluded from the assessment of hedge
effectiveness and are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not
designated as hedges for accounting purposes are recognized in earnings.
Foreign Currency Risk. Certain forecasted transactions and assets are exposed to foreign currency risk. We monitor
our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions.
Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are
designated as cash-flow hedging instruments under Statement of Financial Accounting Standards (SFAS) 133,
Accounting for Derivative Instruments and Hedging Activities. Principal currencies hedged include the Euro, Japanese
yen, British pound, and Canadian dollar. Certain non-U.S. dollar denominated securities are hedged using foreign
exchange forward contracts that are designated as fair-value hedging instruments under SFAS 133. Certain options and
forwards not designated as hedging instruments under SFAS 133 are also used to hedge the impact of the variability in
exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other
foreign currency exposures.
Equities Price Risk. Equity investments are subject to market price risk. From time to time, we use and designate
options to hedge fair values and cash flows on certain equity securities. We determine the security, or forecasted sale
thereof, selected for hedging by evaluating market conditions, up-front costs, and other relevant factors. Once
established, the hedges are not dynamically managed or traded, and are generally not removed until maturity. Certain
options, futures and swap contracts, not designated as hedging instruments under SFAS 133, are also used to manage
equity exposures.
Interest Rate Risk. Fixed-income securities are subject to interest rate risk. The fixed-income portfolio is diversified and
consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and future
contracts and over-the-counter swap contracts, not designated as hedging instruments under SFAS 133, to hedge interest
rate risk.
Other Derivatives. Swap contracts, not designated as hedging instruments under SFAS 133, are used to manage
exposures to credit risks. In addition, we may invest in warrants to purchase securities of other companies as a strategic
investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as
hedging instruments. To Be Announced forward purchase commitments of mortgage-backed assets are also considered
derivatives in cases where physical delivery of the assets are not taken at the earliest available delivery date. All
derivative instruments not designated as hedging instruments are recorded at fair value, with changes in value recognized
in the income statement during the period of change.