Derivative Instruments and Hedging Activities

6 Months Ended

Apr. 26, 2020

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

Derivative Financial Instruments

Applied conducts business in a number of foreign countries, with certain transactions denominated in local currencies, such as the Japanese yen, euro, Israeli shekel and Taiwanese dollar. Applied uses derivative financial instruments, such as forward exchange contracts and currency option contracts, to hedge certain forecasted foreign currency denominated transactions expected to occur typically within the next 24 months. The purpose of Applied’s foreign currency management is to mitigate the effect of exchange rate fluctuations on certain foreign currency denominated revenues, costs and eventual cash flows. The terms of currency instruments used for hedging purposes are generally consistent with the timing of the transactions being hedged.

Applied does not use derivative financial instruments for trading or speculative purposes. Derivative instruments and hedging activities, including foreign currency exchange and interest rate contracts, are recognized on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of any hedges, are recognized currently in earnings. All of Applied’s derivative financial instruments are recorded at their fair value in other current assets or in accounts payable and accrued expenses. 

Hedges related to anticipated transactions are designated and documented at the inception of the hedge as cash flow hedges and foreign exchange derivatives are typically entered into once per month. Cash flow hedges are evaluated for effectiveness quarterly. The effective portion of the gain or loss on these hedges is reported as a component of AOCI in stockholders’ equity and is reclassified into earnings when the hedged transaction affects earnings. The majority of the after-tax net income or loss related to foreign exchange derivative instruments included in AOCI as of April 26, 2020 is expected to be reclassified into earnings within 12 months. Prior to adopting the new accounting guidance for hedge accounting, changes in the fair value of currency forward exchange and option contracts due to changes in time value were excluded from the assessment of effectiveness. Subsequent to the adoption of the new accounting guidance, only changes in the fair value of option contracts due to changes in time value were excluded from the assessment of effectiveness. The initial value of this excluded component is amortized on a straight-line basis over the life of the hedging instrument and recognized in the financial statement line item to which the hedge relates. Both ineffective hedge amounts and hedge components excluded from the assessment of effectiveness are recognized in earnings. If the transaction being hedged is no longer probable to occur, or if a portion of any derivative is deemed to be ineffective, Applied promptly recognizes the gain or loss on the associated financial instrument in earnings. The amount recognized due to discontinuance of cash flow hedges that were probable not to occur by the end of the originally specified time period was not material for the three and six months ended April 26, 2020 and April 28, 2019.

Additionally, forward exchange contracts are generally used to hedge certain foreign currency denominated assets or liabilities. These derivatives are typically entered into once per month and are not designated for hedge accounting treatment. Accordingly, changes in the fair value of these hedges are recorded in earnings to offset the changes in the fair value of the assets or liabilities being hedged.

The fair values of foreign exchange derivative instruments as of April 26, 2020 and October 27, 2019 were not material.

Applied is also exposed to interest rate risk associated with its potential future borrowings. During the six months ended April 26, 2020, Applied entered into a series of interest rate contracts to hedge against the variability of cash flows due to changes in the benchmark interest rate of fixed rate debt. These instruments were designated as cash flow hedges at inception and will be settled upon the issuance of debt.

The gain (loss) on derivatives in cash flow hedging relationships recognized in AOCI for derivatives designated as hedging instruments for the indicated periods were as follows:

	Three Months Ended				Six Months Ended
	April 26, 2020		April 28, 2019		April 26, 2020		April 28, 2019
	(In millions)
Derivatives in Cash Flow Hedging Relationships:
Foreign exchange contracts	$	(3)	$	11	$	4	$	(5)
Interest rate contracts	(162)		—		(180)		—
Total	$	(165)	$	11	$	(176)	$	(5)

The effects of derivative instruments and hedging activities on the Consolidated Condensed Statements of Operations were as follows:

	Three Months Ended
	April 26, 2020						April 28, 2019
			Derivatives in Cash Flow Hedging Relationships						Derivatives in Cash Flow Hedging Relationships
	Total Amount Presented in the Condensed Consolidated Statement of Operations in which the Effects of Cash Flow Hedges are Recorded		Amount of Gain or (Loss) Reclassified from AOCI into Income		Amounts of Gain (Loss) Excluded from Effectiveness Testing Recognized in Income		Total Amount Presented in the Condensed Consolidated Statement of Operations in which the Effects of Cash Flow Hedges are Recorded		Amount of Gain or (Loss) Reclassified from AOCI into Income		Amounts of Gain (Loss) Excluded from Effectiveness Testing Recognized in Income
	(In millions)
Foreign Exchange Contracts:
Net Sales	$	3,957	$	2	$	1	$	3,539	$	—	$	—
Cost of products sold	$	2,208	(3)		(1)		$	2,009	(2)		4
Research, development and engineering	$	550	(1)		—		$	508	—		—
General and administrative	$	137	—		—		$	113	2		(2)
Interest Rate Contracts:
Interest expense	$	61	—		—		$	60	(2)		—
			$	(2)	$	—			$	(2)	$	2

	Six Months Ended
	April 26, 2020						April 28, 2019
			Derivatives in Cash Flow Hedging Relationships						Derivatives in Cash Flow Hedging Relationships
	Total Amount Presented in the Consolidated Statement of Operations in which the Effects of Cash Flow Hedges are Recorded		Amount of Gain or (Loss) Reclassified from AOCI into Income		Amounts of Gain (Loss) Excluded from Effectiveness Testing Recognized in Income		Total Amount Presented in the Consolidated Statement of Operations in which the Effects of Cash Flow Hedges are Recorded		Amount of Gain or (Loss) Reclassified from AOCI into Income		Amounts of Gain (Loss) Excluded from Effectiveness Testing Recognized in Income
	(In millions)
Foreign Exchange Contracts:
Net Sales	$	8,119	$	1	$	3	$	7,292	$	—	$	—
Cost of products sold	$	4,512	(1)		(1)		$	4,097	10		9
Research, development and engineering	$	1,102	—		—		$	1,024	—		—
Marketing and selling	$	265	—		—		$	264	—		—
General and administrative	$	266	—		—		$	223	(3)		(3)
Interest Rate Contracts:
Interest expense	$	120	(1)		—		$	120	(2)		—
			$	(1)	$	2			$	5	$	6

		Amount of Gain or (Loss)  Recognized in Income
		Three Months Ended				Six Months Ended
	Location of Gain or (Loss) Recognized in Income	April 26, 2020		April 28, 2019		April 26, 2020		April 28, 2019
		(In millions)
Derivatives Not Designated as Hedging Instruments
Foreign exchange contracts	General and administrative	$	—	$	6	$	—	$	(4)
Foreign exchange contracts	Interest and other income, net	(8)		—		(4)		—
Total return swaps - deferred compensation	Cost of products sold	(1)		—		(1)		—
Total return swaps - deferred compensation	Operating expenses	(10)		—		(10)		—
Total return swaps - deferred compensation	Interest and other income, net	(1)		—		(1)		—
Total		$	(20)	$	6	$	(16)	$	(4)

Credit Risk Contingent Features

If Applied’s credit rating were to fall below investment grade, it would be in violation of credit risk contingent provisions of the derivative instruments discussed above, and certain counterparties to the derivative instruments could request immediate payment on derivative instruments in net liability positions. The aggregate fair value of all derivative instruments with credit-risk related contingent features that were in a net liability position was immaterial as of April 26, 2020.

Entering into derivative contracts with banks exposes Applied to credit-related losses in the event of the banks’ nonperformance. However, Applied’s exposure is not considered significant.