BP Annual Report and Form 20-F 2011 - Company Reporting

Notes on financial statements1. Significant accounting policies continuedLeasesFinance leases, which transfer to the group substantially all the risks andbenefits incidental to ownership of the leased item, are capitalized at thecommencement of the lease term at the fair value of the leased propertyor, if lower, at the present value of the minimum lease payments. Financecharges are allocated to each period so as to achieve a constant rate ofinterest on the remaining balance of the liability and are charged directlyagainst income.Capitalized leased assets are depreciated over the shorter ofthe estimated useful life of the asset or the lease term. Operating leasepayments are recognized as an expense in the income statement on astraight-line basis over the lease term. For both finance and operatingleases, contingent rents are recognized in the income statement in theperiod in which they are incurred.Derivative financial instruments and hedging activitiesThe group uses derivative financial instruments to manage certainexposures to fluctuations in foreign currency exchange rates, interestrates and commodity prices as well as for trading purposes. Suchderivative financial instruments are initially recognized at fair value on thedate on which a derivative contract is entered into and are subsequentlyremeasured at fair value. Derivatives are carried as assets when the fairvalue is positive and as liabilities when the fair value is negative.Contracts to buy or sell a non-financial item that can be settled net incash or another financial instrument, or by exchanging financial instrumentsas if the contracts were financial instruments, with the exception ofcontracts that were entered into and continue to be held for the purposeof the receipt or delivery of a non-financial item in accordance with thegroup’s expected purchase, sale or usage requirements, are accounted foras financial instruments.Gains or losses arising from changes in the fair value of derivativesthat are not designated as effective hedging instruments are recognized inthe income statement.For the purpose of hedge accounting, hedges are classified as:• Fair value hedges when hedging exposure to changes in the fair value ofa recognized asset or liability.• Cash flow hedges when hedging exposure to variability in cash flows thatis either attributable to a particular risk associated with a recognized assetor liability or a highly probable forecast transaction.Hedge relationships are formally designated and documented atinception, together with the risk management objective and strategy forundertaking the hedge. The documentation includes identification of thehedging instrument, the hedged item or transaction, the nature of therisk being hedged, and how the entity will assess the hedging instrumenteffectiveness in offsetting the exposure to changes in the hedged item’sfair value or cash flows attributable to the hedged item. Such hedgesare expected at inception to be highly effective in achieving offsettingchanges in fair value or cash flows. Hedges meeting the criteria for hedgeaccounting are accounted for as follows:Fair value hedgesThe change in fair value of a hedging derivative is recognized in profit or loss.The change in the fair value of the hedged item attributable to the risk beinghedged is recorded as part of the carrying value of the hedged item and isalso recognized in profit or loss.The group applies fair value hedge accounting for hedging fixedinterest rate risk on borrowings. The gain or loss relating to the effectiveportion of the interest rate swap is recognized in the income statementwithin finance costs, offsetting the amortization of the interest on theunderlying borrowings.If the criteria for hedge accounting are no longer met, or if thegroup revokes the designation, the adjustment to the carrying amount of ahedged item for which the effective interest method is used is amortized toprofit or loss over the period to maturity.Cash flow hedgesFor cash flow hedges, the effective portion of the gain or loss on thehedging instrument is recognized within other comprehensive income,while the ineffective portion is recognized in profit or loss. Amounts takento other comprehensive income are transferred to the income statementwhen the hedged transaction affects profit or loss. The gain or lossrelating to the effective portion of interest rate swaps hedging variable rateborrowings is recognized in the income statement within finance costs.Where the hedged item is the cost of a non-financial asset orliability, such as a forecast transaction for the purchase of property, plantand equipment, the amounts recognized within other comprehensiveincome are transferred to the initial carrying amount of the non-financialasset or liability.If the hedging instrument expires or is sold, terminated or exercisedwithout replacement or rollover, or if its designation as a hedge is revoked,amounts previously recognized within other comprehensive income remain inequity until the forecast transaction occurs and are transferred to the incomestatement or to the initial carrying amount of a non-financial asset or liabilityas above. If a forecast transaction is no longer expected to occur, amountspreviously recognized in equity are reclassified to the income statement.Embedded derivativesDerivatives embedded in other financial instruments or other host contractsare treated as separate derivatives when their risks and characteristics arenot closely related to those of the host contract. Contracts are assessed forembedded derivatives when the group becomes a party to them, includingat the date of a business combination. Embedded derivatives are measuredat fair value at each balance sheet date. Any gains or losses arising fromchanges in fair value are taken directly to the income statement.Provisions, contingencies and reimbursement assetsProvisions are recognized when the group has a present obligation (legalor constructive) as a result of a past event, it is probable that an outflowof resources embodying economic benefits will be required to settlethe obligation and a reliable estimate can be made of the amount of theobligation. Where appropriate, the future cash flow estimates are adjustedto reflect risks specific to the liability.If the effect of the time value of money is material, provisions aredetermined by discounting the expected future cash flows at a pre-taxrisk-free rate that reflects current market assessments of the time valueof money. Where discounting is used, the increase in the provision due tothe passage of time is recognized within finance costs. Provisions are splitbetween amounts expected to be settled within 12 months of the balancesheet date (current) and amounts expected to be settled later (non-current).Contingent liabilities are possible obligations whose existence will only beconfirmed by future events not wholly within the control of the group, orpresent obligations where it is not probable that an outflow of resourceswill be required or the amount of the obligation cannot be measured withsufficient reliability.Contingent liabilities are not recognized in the financial statementsbut are disclosed unless the possibility of an outflow of economic resourcesis considered remote.Where the group makes contributions into a separately administeredfund for restoration, environmental or other obligations, which it doesnot control, and the group’s right to the assets in the fund is restricted,the obligation to contribute to the fund is recognized as a liability whereit is probable that such additional contributions will be made. The grouprecognizes a reimbursement asset separately, being the lower of theamount of the associated restoration, environmental or other provision andthe group’s share of the fair value of the net assets of the fund available tocontributors.186 BP Annual Report and Form 20-F 2011