Derivative Financial Instruments and Hedging Activities

9 Months Ended

Sep. 30, 2011

Derivative Instruments and Hedging Activities Disclosure [Abstract]

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

In the normal course of business, Eaton is exposed to certain risks related to fluctuations in interest rates, foreign currency exchange rates and commodity prices. The Company uses various derivative and non-derivative financial instruments, primarily interest rate swaps, foreign currency forward exchange contracts, foreign currency swaps and, to a lesser extent, commodity contracts, to manage risks from these market fluctuations. The instruments used by Eaton are straightforward, non-leveraged instruments. The counterparties to these instruments are financial institutions with strong credit ratings. Eaton maintains control over the size of positions entered into with any one counterparty and regularly monitors the credit rating of these institutions. Such instruments are not purchased and sold for trading purposes.

Derivative financial instruments are accounted for at fair value and recognized as assets or liabilities in the Condensed Consolidated Balance Sheets. Accounting for the gain or loss resulting from the change in the fair value of the derivative financial instrument depends on whether it has been designated, and is effective, as part of a hedging relationship and, if so, as to the nature of the hedging activity. Eaton formally documents all relationships between derivative financial instruments accounted for as hedges and the hedged item, as well as its risk-management objective and strategy for undertaking the hedge transaction. This process includes linking all derivative financial instruments to a recognized asset or liability, specific firm commitment, forecasted transaction, or net investment in a foreign operation. These financial instruments can be designated as:

• Hedges of the change in the fair value of a recognized fixed-rate asset or liability, or the firm commitment to acquire such an asset or liability (a fair value hedge); for these hedges, the gain or loss from the derivative financial instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in income during the period of change in fair value.

• Hedges of the variable cash flows of a recognized variable-rate asset or liability, or the forecasted acquisition of such an asset or liability (a cash flow hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive income (loss) and reclassified to income in the same period when the gain or loss on the hedged item is included in income.

• Hedges of the foreign currency exposure related to a net investment in a foreign operation (a net investment hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive income (loss) and reclassified to income in the same period when the gain or loss related to the net investment in the foreign operation is included in income.

The gain or loss from a derivative financial instrument designated as a hedge that is effective is classified in the same line of the Consolidated Statements of Income as the offsetting loss or gain on the hedged item. The change in fair value of a derivative financial instrument that is not effective as a hedge is immediately recognized in income.

For derivatives that are not designated as a hedge, any gain or loss is immediately recognized in income. The majority of derivatives used in this manner relate to risks resulting from assets or liabilities denominated in a foreign currency and certain commodity contracts that arise in the normal course of business. During the third quarter and first nine months of 2011, Eaton incurred losses associated with commodity hedge contracts of $23 and $19, respectively. These losses were incurred due to significant declines in metal prices during primarily the last two weeks in September. Gains and losses associated with commodity hedge contracts are reported in Cost of products sold.

Derivative Financial Statement Impacts

The fair value of derivative financial instruments recognized in the Condensed Consolidated Balance Sheets follows:

	Notional amount		Other  current assets		Other long-term assets		Other current liabilities		Type of hedge	Term
September 30, 2011
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	540	$	—	$	67	$	—	Fair value	2 to 23 years
Foreign currency exchange contracts	331		5		—		12		Cash flow	12 to 36 months
Commodity contracts	50		—		—		12		Cash flow	12 months
Total			$	5	$	67	$	24
Derivatives not designated as hedges
Foreign currency exchange contracts	$	2,845	$	24			$	25		12 months
Commodity contracts	114		—				22			12 months
Total			$	24			$	47
December 31, 2010
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	540	$	—	$	42	$	—	Fair value	2 to 23 years
Foreign currency exchange contracts	227		4		—		5		Cash flow	12 to 36 months
Commodity contracts	39		8		—		—		Cash flow	12 months
Cross currency swaps	75		2		—		—		Net investment	12 months
Total			$	14	$	42	$	5
Derivatives not designated as hedges
Foreign currency exchange contracts	$	2,777	$	20			$	19		12 months
Commodity contracts	102		17				—			12 months
Total			$	37			$	19

The foreign currency exchange contracts shown in the table above as derivatives not designated as hedges are primarily contracts entered into to manage foreign currency volatility or exposure on intercompany sales and loans. While Eaton does not elect hedge accounting treatment for these derivatives, Eaton targets managing 100% of the intercompany balance sheet exposure to minimize the effect of currency volatility related to the movement of goods and services in the normal course of its operations. This activity represents the great majority of these foreign currency exchange contracts.

Amounts recognized in Accumulated other comprehensive income (loss) follow:

	Three months ended September 30
	2011						2010
	Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)			Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)
Derivatives designated as cash flow hedges
Foreign currency exchange contracts	$	(7	)	$	(1	)	$	3		$	1
Commodity contracts	(12		)	2			5			—
Derivatives designated as net investment hedges
Cross currency swaps	—			—			(16		)	—
Total	$	(19	)	$	1		$	(8	)	$	1

	Nine months ended September 30
	2011						2010
	Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)			Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)
Derivatives designated as cash flow hedges
Foreign currency exchange contracts	$	(6	)	$	(1	)	$	2		$	1
Commodity contracts	(13		)	7			2			5
Derivatives designated as net investment hedges
Cross currency swaps	1			—			(12		)	—
Total	$	(18	)	$	6		$	(8	)	$	6

Gains and losses reclassified from Accumulated other comprehensive income (loss) to the Consolidated Statements of Income were recognized in Cost of products sold.

Amounts recognized in net income follow:

	Three months ended September 30						Nine months ended September 30
	2011			2010			2011			2010
Derivatives designated as fair value hedges
Fixed-to-floating interest rate swaps	$	23		$	13		$	25		$	49
Related long-term debt converted to floating interest    rates by interest rate swaps	(23		)	(13		)	(25		)	(49		)
	$	—		$	—		$	—		$	—

Gains and losses described above were recognized in Interest expense.