Hydro Annual Report 2011b

F16
FINANCIAL STATEMENTS
Note 3 - Basis of presentation and measurement of fair value
Embedded derivatives
Hydro measures embedded derivatives that are separated (i.e. bifurcated) from the host contract by comparing the forward
curve at contract inception to the forward curve as of the balance sheet date. Changes in the present value of the cash flows
related to the embedded derivative are recognized in the balance sheet and in the income statement. Forward curves are
established as described above under Derivatives. For contracts that contain embedded caps or floors, Asian option valuation
models are used.
Note 4 - Critical accounting judgment and key sources of estimation uncertainty
The application of accounting policies require that management make estimates and judgments in determining certain
revenues, expenses, assets, and liabilities. The following accounting policies represent areas that are considered more critical,
involving a higher degree of judgment and complexity.
Impairment of non-current assets
IAS 36 requires that Hydro assess conditions that could cause an asset to become impaired and to test recoverability of
potentially impaired assets. These conditions include significant decrease in the market value of the asset, changes in Hydro's
business plan for the asset or a significant adverse change in the business and legal climate. Each Cash Generating Unit (CGU)
or individual asset is reviewed for impairment indicators. Most of Hydro's assets are assigned to CGUs, which is the lowest
level where largely independent cash flows are deemed to exist. The identification of CGUs involves judgment, including
assessment of where active markets exist, and the level of interdependency of cash inflows. For Hydro, the CGU is usually the
individual plant, unless the asset or asset group is an integral part of a value chain where no independent prices for the
intermediate products exist, a group of plants is combined and managed to serve a common market, or where circumstances
otherwise indicate significant interdependencies.
If a loss in value is indicated, the recoverable amount is estimated as the higher of the asset or CGU's fair value less cost to sell,
or its value in use. Directly observable market prices rarely exist for our assets, however, fair value may be estimated based on
recent transactions on comparable assets, bids or other discussions of potential transactions involving the asset, or internal
models used by Hydro for transactions involving the same type of assets. Calculation of value in use is a discounted cash flow
calculation based on continued use of the assets in its present condition, excluding potential exploitation of improvement or
expansion potential.
Determination of the recoverable amount involves management estimates on highly uncertain matters, such as commodity
prices and their impact on markets and prices for upgraded products, development in demand, inflation and operating
expenses, and technology changes. We use internal business plans, quoted forward prices and our best estimate of commodity
prices, currency rates, discount rates and other relevant information. In periods when observed prices in the market are
considered inconsistent because they over time render either exceptionally positive cash flows or consistently negative cash flows
for a majority of market participants over time, adjustments in the mid to long term prices are made in order to reflect Hydro's
current expectations of net cash flows. A detailed forecast is developed for a period of three to five years with projections
thereafter. Hydro does not include a general growth factor above inflation to volumes or cash flows for the purpose of
impairment tests, however, market recovery towards previously observed levels is considered. Estimated cash flows are
discounted with a risk adjusted discount rate derived as the weighted average cost of capital (WACC) for a similar business in
the same business environment. For Hydro's businesses the pre tax nominal discount rate is estimated at between 9 and 12
percent (2010: 8.75-13.5 percent). The variance in discount rates mainly results from differences in risk free interest rates and
tax levels in different regions. For further information about impairment tests, see note 13 Impairment of non-current assets.
Financial instruments
Certain commodity contracts are deemed to be financial instruments under IAS 39 or to contain embedded derivatives which
are required to be recognized at fair value, with subsequent changes in fair value impacting the income statement. Determining
whether contracts qualify as financial instruments at fair value involves evaluation of markets, Hydro's use of those instruments
and historic or planned use of physically delivered products under such contracts. Determining whether embedded derivatives
are required to be separated and accounted for at fair value involve assessing price correlations and normal market pricing
mechanisms for relevant products and market places. Where no directly observable market prices exist, fair value is estimated
through valuation models which rely on internal assumptions as well as observable market information such as forward curves,
yield curves and interest rates. Market stability impacts the reliability of observed prices and other market information, and
consequently, the extent of judgment necessary to estimate appropriate market prices for valuation purposes. Volatility also