Note 1 – Summary of Significant Accounting Policies

Nature of Operations

Toyota Motor Credit Corporation (“TMCC”) is wholly-owned by Toyota Financial Services International Corporation (“TFSIC”), a California corporation, which is a wholly-owned subsidiary of Toyota Financial Services Corporation (“TFSC”), a Japanese corporation. Prior to July 1, 2016, TFSIC was known as Toyota Financial Services Americas Corporation. TFSC, in turn, is a wholly-owned subsidiary of Toyota Motor Corporation (“TMC”), a Japanese corporation. TFSC manages TMC’s worldwide financial services operations. References herein to “we”, “our”, and “us” denote TMCC and its consolidated subsidiaries. TMCC is marketed under the brands of Toyota Financial Services and Lexus Financial Services.

We provide a variety of finance and insurance products to authorized Toyota and Lexus dealers or dealer groups and, to a lesser extent, other domestic and import franchise dealers (collectively referred to as “dealers”) and their customers in the United States of America (excluding Hawaii) (the “U.S.”) and Puerto Rico. Our business is substantially dependent upon the sale of Toyota and Lexus vehicles. Vehicles manufactured under the Scion brand were transitioned to the Toyota brand in August 2016.

Our products fall primarily into the following product categories:

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Finance - We acquire retail installment sales contracts from dealers in the U.S. and Puerto Rico (“retail contracts”) and leasing contracts accounted for as operating leases (“lease contracts”) from dealers in the U.S. We collectively refer to our retail and lease contracts as the “consumer portfolio”. We also provide dealer financing, including wholesale financing, working capital loans, revolving lines of credit and real estate financing to dealers in the U.S. and Puerto Rico. We collectively refer to our dealer financing portfolio as the “dealer portfolio”.

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Insurance - Through Toyota Motor Insurance Services, Inc., a wholly-owned subsidiary, and its insurance company subsidiaries (collectively referred to as “TMIS”), we provide marketing, underwriting, and claims administration for products that cover certain risks of dealers and their customers in the U.S. We also provide coverage and related administrative services to certain of our affiliates in the U.S.

Our finance operations are located in the U.S. and Puerto Rico with earning assets principally sourced through Toyota and Lexus dealers. As of March 31, 2017, approximately 22 percent of retail and lease contracts were concentrated in California, 11 percent in Texas, 8 percent in New York, and 5 percent in New Jersey. Our insurance operations are located in the U.S. As of March 31, 2017, approximately 26 percent of insurance policies and contracts were concentrated in California, 7 percent in New York and 5 percent in New Jersey. Any material adverse changes to the economies or applicable laws in these states could have an adverse effect on our financial condition and results of operations.

In December 2014, we entered into an agreement for the sale of certain assets and liabilities related to our industrial equipment retail, lease, and dealer portfolios (hereinafter the “commercial finance business”) to Toyota Industries Commercial Finance, Inc. (“TICF”), a newly-formed subsidiary of Toyota Industries Corporation, which forms part of the group of companies known as the Toyota Group and is a related party to TMCC. As discussed in our Form 10-K for fiscal 2016, the sale was completed on October 1, 2015 and resulted in cash proceeds of $2.3 billion and a gain of $197 million that was reflected in our results of operations in fiscal 2016. The sale of our commercial finance business did not meet the criteria to be presented as a discontinued operation.

Note 1 – Summary of Significant Accounting Policies (Continued)

Basis of Presentation

Our accounting and financial reporting policies conform to accounting principles generally accepted in the United States of America (“U.S. GAAP”). Certain prior period amounts have been reclassified to conform to the current year presentation.

Related party transactions presented in the Consolidated Financial Statements are disclosed in Note 15 – Related Party Transactions.

Principles of Consolidation

The consolidated financial statements include the accounts of TMCC, its wholly-owned subsidiaries and all variable interest entities (“VIE”) of which we are the primary beneficiary. All intercompany transactions and balances have been eliminated.

Variable Interest Entities

A VIE is an entity that either (i) has insufficient equity to permit the entity to finance its activities without additional subordinated financial support or (ii) has equity investors who lack the characteristics of a controlling financial interest. The primary beneficiary of a VIE is the party with both the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and the obligation to absorb the losses or the right to receive benefits that could potentially be significant to the VIE.

To assess whether we have the power to direct the activities of a VIE that most significantly impact its economic performance, we consider all the facts and circumstances including our role in establishing the VIE and our ongoing rights and responsibilities. This assessment includes identifying the activities that most significantly impact the VIE’s economic performance and identifying which party, if any, has power over those activities. In general, the party that makes the most significant decisions affecting the VIE is determined to have the power to direct the activities of the VIE. To assess whether we have the obligation to absorb the losses or the right to receive benefits that could potentially be significant to the VIE, we consider all of our economic interests, including debt and equity interests, servicing rights and fee arrangements, and any other variable interests in the VIE. If we determine that we are the party with the power to make the most significant decisions affecting the VIE, and we have an obligation to absorb the losses or the right to receive benefits that could potentially be significant to the VIE, then we consolidate the VIE.

We perform ongoing reassessments, usually quarterly, of whether we are the primary beneficiary of a VIE. The reassessment process considers whether we have acquired or divested the power to direct the most significant activities of the VIE through changes in governing documents or other circumstances. We also reconsider whether entities previously determined not to be VIEs have become VIEs, based on new events, and therefore could be subject to the VIE consolidation framework.

Refer to Note 10 – Variable Interest Entities for additional discussion and disclosure.

Note 1 – Summary of Significant Accounting Policies (Continued)

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Because of inherent uncertainty involved in making estimates, actual results could differ from those estimates and assumptions. The accounting estimates that are most important to our business are the determination of residual value relating to our investments in operating leases and the allowance for credit losses as well as estimates related to the fair value of our derivative instruments, marketable securities and other financial instruments.

Revenue Recognition

Operating Lease Revenues

Operating lease revenues are recorded to income on a straight-line basis over the term of the lease. Incremental direct fees and costs received or paid in connection with the acquisition of operating leases, including incentive and rate participation payments made to dealers and acquisition fees collected from customers, are capitalized or deferred and amortized on a straight-line basis over the term of the related contracts. Payments received on affiliate sponsored special rate programs (“subvention”) are deferred and recognized on a straight-line basis over the term of the related contracts. Operating lease revenue is recorded net of sales taxes collected from customers. Included in operating lease revenues are other fees, including late fees and other service charges, the amounts of which are not significant to total operating lease revenue.

Retail and Dealer Financing Revenues

Revenues associated with retail and dealer financing are recognized so as to approximate a constant effective yield over the contract term. Incremental direct fees and costs incurred in connection with the acquisition of retail contracts and dealer financing receivables, including incentive and rate participation payments made to dealers, are capitalized and amortized so as to approximate a constant effective yield over the term of the related contracts. Payments received on subvention programs are deferred and recognized to approximate a constant effective yield over the term of the related contracts. Included in financing revenues are other fees, including late fees and other service charges, the amounts of which are not significant to total financing revenues.
Note 1 – Summary of Significant Accounting Policies (Continued)

Insurance Earned Premiums and Contract Revenues

Revenues from providing coverage under various contractual agreements are recognized over the term of the coverage in relation to the timing and level of anticipated claims and administrative expenses. Revenues from insurance policies, net of premiums ceded to reinsurers, are earned over the terms of the respective policies in proportion to the estimated loss development. Management relies on historical loss experience as a basis for establishing earnings factors used to recognize revenue over the term of the contract or policy.

The portion of premiums and contract revenues applicable to the unexpired terms of the agreements is recorded as unearned insurance premiums and contract revenues. Policies and contracts sold range in term from 3 to 120 months. Certain costs of acquiring new policies and contracts, consisting primarily of dealer commissions and premium taxes, are deferred and amortized over the term of the related policies on the same basis as the revenues are earned. The effect of subsequent cancellations is recorded as an offset to unearned insurance premiums and contract revenues.

Service commissions and fees are recognized over the term of the coverage in relation to the timing of services performed.

Depreciation on Operating Leases

Depreciation on operating leases is recognized using the straight-line method over the lease term, typically two to five years. The depreciable basis is the original acquisition cost of the vehicle less the estimated residual value of the vehicle at the end of the lease term. During the lease term, adjustments to depreciation expense reflecting revised estimates of expected residual values at the end of the lease terms are recorded prospectively on a straight-line basis over the remaining lease term.

Note 1 – Summary of Significant Accounting Policies (Continued)

Allowance for Credit Losses

We maintain an allowance for credit losses to cover probable and estimable losses incurred on our finance receivables and investments in operating leases resulting from the failure of customers or dealers to make contractual payments. Management evaluates the allowance at least quarterly, considering a variety of factors and assumptions to determine whether the allowance is considered adequate to cover probable and estimable losses incurred as of the balance sheet date.

Management develops and documents the allowance for credit losses on finance receivables based on two portfolio segments. The determination of portfolio segments is based primarily on the qualitative consideration of the nature of our business operations and the characteristics of the underlying finance receivables. On October 1, 2015, we completed the sale of our commercial finance business segment to TICF. Subsequent to this sale we have the following two portfolio segments within finance receivables:

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Retail Loan Portfolio Segment – The retail loan portfolio segment consists of retail contracts acquired from dealers in the U.S. and Puerto Rico. Under a retail contract, we are granted a security interest in the underlying collateral which consists primarily of Toyota and Lexus vehicles. Based on the common risk characteristics associated with the finance receivables, the retail loan portfolio segment is considered a single class of finance receivable.

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Dealer Products Portfolio Segment – The dealer products portfolio segment consists of wholesale financing, working capital loans, revolving lines of credit and real estate loans to dealers in the U.S. and Puerto Rico. Wholesale financing is primarily collateralized by new or used vehicle inventory with the outstanding balance fluctuating based on the level of inventory. Working capital loans and revolving lines of credit are granted for working capital purposes and are secured by dealership assets. Real estate loans are collateralized by the underlying real estate, are underwritten primarily on a loan-to-value basis and are typically for a fixed term. Based on the risk characteristics associated with the underlying finance receivables, the dealer products portfolio segment consists of three classes of finance receivables: wholesale, working capital (including revolving lines of credit), and real estate.

We also separately develop and document the allowance for credit losses for investments in operating leases. Investments in operating leases are not within the scope of accounting guidance governing the disclosure of portfolio segments.

Note 1 – Summary of Significant Accounting Policies (Continued)

Methodology Used to Develop the Allowance for Credit Losses

Retail Loan Portfolio Segment and Investments in Operating Leases

The level of credit risk in our retail loan portfolio segment and our investments in operating leases is influenced primarily by two factors: default frequency and loss severity, which in turn are influenced by various factors such as economic conditions, the used vehicle market, purchase quality mix, contract term length, and collection strategies and practices.

We evaluate the retail loan portfolio segment and investments in operating leases using methodologies that include roll rate, credit risk grade/tier, and vintage analysis. We review and analyze external factors, including changes in economic conditions, actual or perceived quality, safety and reliability of Toyota and Lexus vehicles, unemployment levels, the used vehicle market, and consumer behavior. In addition, internal factors, such as purchase quality mix and operational changes are also considered in the analyses.

We utilize a loss emergence period assumption in developing our allowance for credit losses. This assumption represents the average length of time between when a loss event first occurs and when the account is charged off. We apply judgment in estimating the loss emergence period using available credit information and trends.

Dealer Products Portfolio Segment

The level of credit risk in our dealer products portfolio segment is influenced primarily by the financial strength of dealers within our portfolio, dealer concentration, collateral quality, and other economic factors. The financial strength of dealers within our portfolio is influenced by, among other factors, general economic conditions, the overall demand for new and used vehicles and the financial condition of automotive manufacturers.

We evaluate the dealer portfolio by aggregating dealer financing receivables into loan-risk pools, which are determined based on the risk characteristics of the loan (e.g. secured by vehicles, real estate or dealership assets). We analyze the loan-risk pools using internally developed risk ratings for each dealer. We also utilize a loss emergence period assumption in developing our allowance for credit losses. The loss emergence period represents the time period between the date at which the loss event is estimated to have occurred and the ultimate realization of that loss through charge-off. In addition, field operations management and our special assets group are consulted each quarter to determine if any specific dealer loan is considered impaired. If impaired loans are identified, specific reserves are established, as appropriate, and the loan is removed from the loan-risk pool for separate monitoring.

Note 1 – Summary of Significant Accounting Policies (Continued)

Accounting for the Allowance for Credit Losses and Impaired Receivables

The majority of the allowance for credit losses covers estimated losses on the retail loan portfolio segment which is collectively evaluated for impairment. The remainder of the allowance for credit losses covers the estimated losses on investments in operating leases and the dealer products portfolio segment. Within the dealer products portfolio segment, we establish specific reserves to cover the estimated losses on individual impaired loans (including loans modified in a troubled debt restructuring). The specific reserves are assessed based on discounted cash flows, the loan’s observable market price, or the fair value of the underlying collateral if the loan is collateral dependent.

Troubled debt restructurings in the retail loan portfolio segment are aggregated when determining the allowance for credit losses. These loans are homogenous in nature and insignificant for individual evaluation and we have determined that the allowance for credit losses for the retail loan portfolio segment would not be materially different if the loans had been individually evaluated for impairment.

Increases to the allowance for credit losses are accompanied by corresponding charges to the Provision for credit losses on our Consolidated Statements of Income. The uncollectible portion of finance receivables and investments in operating leases is charged to the allowance for credit losses at the earlier of when an account is deemed to be uncollectible or when an account is greater than 120 days past due. In the event we repossess the collateral, the receivable is charged-off and we record the collateral at its estimated fair value less costs to sell and report it in Other assets in our Consolidated Balance Sheets. Recoveries of finance receivables and investments in operating leases previously charged off as uncollectible are credited to the allowance for credit losses.

Refer to Note 6 – Allowance for Credit Losses for additional discussion and disclosure.

Insurance Losses and Loss Adjustment Expenses

Insurance losses and loss adjustment expenses include amounts paid and accrued for loss events that are known and have been recorded as claims, estimates of losses incurred but not reported that are based on actuarial estimates and historical loss development patterns, and loss adjustment expenses that are expected to be incurred in connection with settling and paying these claims.

Accruals for unpaid losses, losses incurred but not reported, and loss adjustment expenses are included in Other liabilities in our Consolidated Balance Sheets. These accruals arising from contractual agreements entered into by TMIS are not significant as of March 31, 2017 and 2016. Estimated liabilities are reviewed regularly, and we recognize any adjustments in the periods in which they are determined. If anticipated losses, loss adjustment expenses, and unamortized acquisition and maintenance costs exceed the recorded unearned premium, a premium deficiency is recognized by first charging any unamortized acquisition costs to expense and then by recording a liability for any excess deficiency.

Cash Equivalents

Cash equivalents represent highly liquid investments with maturities of three months or less at purchase and may include money market instruments, commercial paper, certificates of deposit or similar instruments.

Restricted Cash

Restricted cash includes customer collections on securitized receivables to be distributed to investors as payments on the related secured debt, which are primarily related to securitization trusts. Restricted cash may also contain amounts unrelated to financing activities which are restricted as to use and proceeds from certain debt issuances for which the use of the cash is restricted.

Note 1 – Summary of Significant Accounting Policies (Continued)

Investments in Marketable Securities

Investments in marketable securities consist of debt and equity securities. Debt and equity securities designated as available-for-sale (“AFS”) are recorded at fair value using quoted market prices where available with unrealized gains or losses included in accumulated other comprehensive income (“AOCI”), net of applicable taxes. Realized gains and losses are determined using either the specific identification method or first in first out method, depending on the type of investment in our portfolio.

Other-than-Temporary Impairment

An unrealized loss exists when the current fair value of an individual security is less than its amortized cost basis. Unrealized losses that are determined to be temporary in nature are recorded, net of tax, in AOCI. We conduct periodic reviews of securities in unrealized loss positions for the purpose of evaluating whether the impairment is other-than-temporary.

As part of our ongoing assessment of other-than-temporary impairment (“OTTI”), we consider a variety of factors. Such factors include the length of time and extent to which the market value of a security has been less than amortized cost, adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of the security and the volatility of the fair value changes.

An OTTI loss with respect to debt securities must be recognized in earnings if we have the intent to sell the debt security or it is more likely than not that we will be required to sell the debt security before recovery of its amortized cost basis. If we have the intent to sell, the cost basis of the security is written down to fair value and the loss is reflected in Realized gains, net on investments in marketable securities in our Consolidated Statements of Income. If we have no intent to sell and we believe that it is more likely than not we will not be required to sell these securities prior to recovery, the credit loss component of the unrealized losses is recognized in Realized gains, net on investments in marketable securities in our Consolidated Statements of Income, while the remainder of the loss is recognized in AOCI. The credit loss component recognized in Realized gains, net on investments in marketable securities in our Consolidated Statements of Income is identified as the portion of the amortized cost of the security not expected to be collected over the remaining term as projected using a cash flow analysis for debt securities.

We perform periodic reviews of our AFS equity securities to determine whether unrealized losses are temporary in nature. We consider our intent and ability to hold the security for a period of time sufficient for recovery of fair value. Where we lack that intent or ability, the equity security’s decline in fair value is deemed to be other-than-temporary. If losses are considered to be other-than-temporary, the cost basis of the security is written down to fair value and the loss is reflected in Realized gains, net on investments in marketable securities in our Consolidated Statements of Income.

Refer to Note 3 – Investments in Marketable Securities for additional discussion and disclosure.

Note 1 – Summary of Significant Accounting Policies (Continued)

Finance Receivables

Our finance receivables consist of the retail loan and the dealer products portfolio segments. Finance receivables recorded on our balance sheet include accrued interest and deferred fees and costs, net of the allowance for credit losses, certain other dealer funds and deferred income.

Finance receivables are classified as held-for-investment if the Company has the intent and ability to hold the receivables for the foreseeable future or until maturity or payoff. As of March 31, 2017 and 2016, all finance receivables were classified as held-for-investment.

Impaired Finance Receivables

A finance receivable is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the terms of the contract. Factors such as payment history, compliance with terms and conditions of the underlying loan agreement and other subjective factors related to the financial stability of the borrower are considered when determining whether a finance receivable is impaired.

Troubled Debt Restructurings

A troubled debt restructuring occurs when a finance receivable is modified through a concession to a borrower experiencing financial difficulty. A finance receivable modified under a troubled debt restructuring is considered to be impaired. In addition, troubled debt restructurings include finance receivables for which the customer has filed for bankruptcy protection. For such finance receivables, we no longer have the ability to modify the terms of the agreement without the approval of the bankruptcy court and the court may impose term modifications that we are obligated to accept.

Nonaccrual Policy

Retail Loan Portfolio Segment

The accrual of revenue is discontinued at the time a retail loan finance receivable is determined to be uncollectible. These finance receivables may be restored to accrual status only when a customer settles all past due deficiency balances and future payments are reasonably assured. For these finance receivables in non-accrual status, subsequent financing revenue is recognized only to the extent a payment is received. Payments are applied first to outstanding interest and then to the unpaid principal balance.

Dealer Products Portfolio Segment

Impaired receivables in the dealer products portfolio segment are placed on nonaccrual status if full payment of principal or interest is in doubt, or when principal or interest is 90 days or more past due. Interest accrued, but not collected at the date a receivable is placed on nonaccrual status, is reversed against interest income. In addition, the amortization of net deferred fees is suspended. Interest income on nonaccrual receivables is recognized only to the extent it is received in cash. Finance receivables are restored to accrual status only when interest and principal payments are brought current and future payments are reasonably assured. Finance receivables in the dealer products portfolio segment are charged off against the allowance for credit losses when the loss has been realized.

Refer to Note 4 – Finance Receivables, Net for additional discussion and disclosure.

Note 1 – Summary of Significant Accounting Policies (Continued)

Investments in Operating Leases

We record our investments in operating leases at acquisition cost, net of deferred fees and costs, deferred income, accumulated depreciation and the allowance for credit losses.

Nonaccrual Policy

The accrual of revenue on investments in operating leases is discontinued at the time an account is determined to be uncollectible. Operating leases may be restored to accrual status only when a customer settles all past due deficiency balances and future payments are reasonably assured. For investments in operating leases in non-accrual status, subsequent operating lease revenue is recognized only to the extent a payment is received. Payments are generally applied first to outstanding interest and then to the unpaid principal balance.

Determination of Residual Value

Residual values of lease contracts are estimated at lease inception by examining external industry data, the anticipated Toyota and Lexus product pipeline and our own experience. Factors considered in this evaluation include, but are not limited to, local, regional and national economic forecasts, new vehicle pricing, new vehicle incentive programs, new vehicle sales, future plans for new Toyota and Lexus product introductions, competitor actions and behavior, product attributes of popular vehicles, the mix and level of used vehicle supply, the level of current used vehicle values, buying and leasing behavior trends, and fuel prices. We use various channels to sell vehicles returned at lease-end.

On a quarterly basis, we review the estimated end-of-term market values of leased vehicles to assess the appropriateness of the carrying values at lease-end. To the extent the estimated end-of-term market value of a leased vehicle is lower than the residual value established at lease inception, the residual value of the leased vehicle is adjusted downward, thereby adjusting depreciation expense, so that the carrying value at lease end will approximate the estimated end-of-term market value. Factors affecting the estimated end-of-term market value are similar to those considered in the evaluation of residual values at lease inception discussed above. These factors are evaluated in the context of their historical trends to anticipate potential future changes in the relationship among these factors. For investments in operating leases, adjustments to depreciation expense are made prospectively on a straight-line basis over the remaining terms of the leases and are included in Depreciation on operating leases in our Consolidated Statements of Income.

We evaluate our investment in operating leases portfolio for potential impairment when we determine a triggering event has occurred. When a triggering event has occurred, we perform a test of recoverability by comparing the expected undiscounted future cash flows (including expected residual values) over the remaining lease terms to the carrying value of the asset group. If the test of recoverability identifies a possible impairment, the asset group’s fair value is measured in accordance with the fair value measurement framework. An impairment charge would be recognized for the amount by which the carrying value of the asset group exceeds its estimated fair value and would be recorded in our Consolidated Statements of Income.

Refer to Note 5 – Investments in Operating Leases, Net for additional discussion and disclosure.

Note 1 – Summary of Significant Accounting Policies (Continued)

Used Vehicles Held for Sale

Used vehicles held for sale, reported in Other assets in our Consolidated Balance Sheets, consist of off-lease vehicles and repossessed vehicles. These vehicles are recorded at the lower of their carrying value or estimated fair value less costs to sell. These vehicles are sold promptly after grounding or repossession.

Debt Issuance Costs

Costs that are direct and incremental to debt issuance are deferred and amortized to interest expense on an effective yield basis over the contractual term of the debt. These costs are presented as a direct deduction from the carrying value of the related debt liability and reported in Debt in our Consolidated Balance Sheets. All other costs related to debt issuance are expensed as incurred.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. If quoted prices in an active market are available, fair value is determined by reference to these prices. If quoted prices are not available, fair value is determined by valuation models that primarily use, as inputs, market-based or independently sourced parameters, including but not limited to interest rates, volatilities, foreign exchange rates and credit curves. Additionally, we may reference prices for similar instruments, quoted prices or recent transactions in less active markets. We use prices and inputs that are current as of the measurement date, including during periods of market disruption. In periods of market disruption, the availability of prices and inputs may be reduced for certain financial instruments. This condition could result in a financial instrument being reclassified from Level 1 to Level 2 or from Level 2 to Level 3.

Level 1: Quoted (unadjusted) prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Quoted prices in active markets for similar assets and liabilities, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability.

Level 3: Unobservable inputs that are supported by little or no market activity and may require significant judgment in order to determine the fair value of the assets and liabilities.

The use of observable and unobservable inputs is reflected in the fair value hierarchy assessment disclosed in the tables within this document. The availability of observable inputs can vary based upon the financial instrument and other factors, such as instrument type, market liquidity and other specific characteristics particular to the financial instrument. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires additional judgment by management. The degree of unobservable inputs can result in financial instruments being classified as or transferred to the Level 3 category.

Note 1 – Summary of Significant Accounting Policies (Continued)

Valuation Methods

We maintain policies and procedures to value financial instruments using the best and most relevant data available. Our Treasury Risk and Analytics Group (“TR&A”) is responsible for determining the fair value of our financial instruments. TR&A consists of quantitative analysts and risk and accounting professionals. Using benchmarking techniques, TR&A reviews our valuation pricing models at least annually to assess their ongoing propriety. As markets and products develop and the pricing for certain products becomes more or less transparent, TR&A refines its valuation methodologies. TR&A reviews the appropriateness of fair value measurements including validation processes, key model inputs, and the reconciliation of period-over-period fluctuations based on changes in key market inputs. Where possible, valuations, including both internally and externally obtained transaction prices, are validated against independent valuation sources. Our Fair Value Working Group (“FVWG”) reviews and approves the fair value measurement results and other relevant data quarterly. The FVWG consists of a cross-section of internal stakeholders who are knowledgeable in the area of financial valuations. All changes to our valuation methodologies are reviewed and approved by the FVWG.

We conduct reviews of our primary pricing vendors to understand and assess the reasonableness of inputs used in their pricing process. While we do not have access to our vendors’ proprietary models, we perform detailed reviews of the pricing process, methodologies and control procedures for each asset class for which prices are provided. Our reviews include examination of the underlying inputs and assumptions for a sample of individual securities selected based on the nature and complexity of the securities. In addition, our pricing vendors have established processes in place for all valuations, which facilitates identification and resolution of potentially erroneous prices. The prices received from our pricing vendors, which represent fair value, are representative of prices that would be received to sell the assets or paid to transfer the liabilities at the measurement date and are classified appropriately in the hierarchy.

Valuation Adjustments

We may make valuation adjustments to ensure that financial instruments are recorded at fair value. These adjustments include amounts to reflect counterparty credit quality, our own creditworthiness, as well as constraints due to market illiquidity or unobservable parameters.

Counterparty Credit Valuation Adjustments – Adjustments are required when the market price (or parameter) is not indicative of the credit quality of the counterparty.

Non-Performance Credit Valuation Adjustments – Adjustments reflect our own non-performance risk when our liabilities are measured at fair value.

Liquidity Valuation Adjustments – Adjustments are necessary when we are unable to observe prices for a financial instrument due to market illiquidity.

Note 1 – Summary of Significant Accounting Policies (Continued)

Recurring Fair Value Measurements

Cash Equivalents

Cash equivalents include money market instruments, certificates of deposit, U.S. government and agency obligations or similar instruments, which represent highly liquid investments with maturities of three months or less at purchase. Where cash equivalent instruments produce a daily net asset value in an active market, we use this value to determine the fair value of the investment and classify the investment in Level 1 of the fair value hierarchy. All other types of cash equivalents are classified in Level 2 of the fair value hierarchy.

Investments in Marketable Securities

The marketable securities portfolio consists of debt and equity securities. We estimate the value of our debt securities using observed transaction prices, independent pricing vendors, and internal pricing models.

Pricing methodologies and inputs to valuation models used by the pricing vendors depend on the security type. Where possible, quoted prices in active markets for identical securities are used to determine the fair value of the investment securities; these securities are classified in Level 1 of the fair value hierarchy. Where quoted prices in active markets are not available, the pricing vendor uses various pricing models for each asset class that are consistent with what market participants use. The inputs and assumptions to the models of the pricing vendors are derived from market observable sources including: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, benchmark securities, bids, offers, and other market-related data. Since many fixed income securities do not trade on a daily basis, the pricing vendors use applicable available information, such as benchmark curves, benchmarking of similar securities, sector groupings, and matrix pricing. These investments are classified in Level 2 of the fair value hierarchy. Our pricing vendors may provide us with valuations that are based on significant unobservable inputs; in such circumstances, we classify these investments in Level 3 of the fair value hierarchy. Valuations obtained from third party pricing vendors are validated to assess their reasonableness.

We may hold investments in actively traded open-end equity and fixed income mutual funds, as well as private placement fixed income mutual funds. Where the funds produce a daily net asset value that is quoted in an active market, we use this value to determine the fair value of the fund investment and classify the investment in Level 1 of the fair value hierarchy. The fair value of funds that produce a daily net asset value that is not quoted in an active market is estimated using the net asset value per share and have appropriately been excluded from the fair value hierarchy.

Derivatives

We estimate the fair value of our derivatives using industry standard valuation models that require observable market inputs, including market prices, yield curves, credit curves, interest rates, foreign exchange rates, volatilities and the contractual terms of the derivative instruments. For derivatives that trade in liquid markets, model inputs can generally be verified and do not require significant management judgment. These derivative instruments are classified in Level 2 of the fair value hierarchy.

Certain other derivative transactions trade in less liquid markets with limited pricing information. For such derivatives, key inputs to the valuation process include quotes from counterparties and other market data used to corroborate and adjust values where appropriate. Other market data includes values obtained from a market participant that serves as a third party pricing vendor. Inputs obtained from counterparties and third party pricing vendors are internally validated using valuation models to assess the reasonableness of changes in factors such as market prices, yield curves, credit curves, interest rates, foreign exchange rates and volatilities. These derivative instruments are classified in Level 3 of the fair value hierarchy.

Our derivative fair value measurements consider assumptions about counterparty credit risk and our own non-performance risk. We consider counterparty credit risk and our own non-performance risk through credit valuation adjustments.

Note 1 – Summary of Significant Accounting Policies (Continued)

Nonrecurring Fair Value Measurements

Impaired Dealer Finance Receivables

For finance receivables within the dealer products portfolio segment for which there is evidence of impairment, we may measure impairment based on discounted cash flows, the loan’s observable market price or the fair value of the underlying collateral if the loan is collateral-dependent. If the loan is collateral-dependent, the fair values of impaired finance receivables are reported at fair value on a nonrecurring basis. The methods used to estimate the fair value of the underlying collateral depends on the specific class of finance receivable. For finance receivables within the wholesale class of finance receivables, the collateral value is generally based on wholesale market value or liquidation value for new and used vehicles. For finance receivables within the real estate class of finance receivables, the collateral value is generally based on appraisals. For finance receivables within the working capital class of finance receivables, the collateral value is generally based on the expected liquidation value of the underlying dealership assets. Adjustments may be performed in circumstances where market comparables are not specific to the attributes of the specific collateral or appraisal information may not be reflective of current market conditions due to the passage of time and the occurrence of market events since receipt of the information. As these valuations utilize unobservable inputs, our impaired finance receivables are classified in Level 3 of the fair value hierarchy.

Impaired Retail Receivables

Retail finance receivables greater than 120 days past due are measured at fair value based on the fair value of the underlying collateral less costs to sell. The fair value of collateral is based on the current average selling prices for like vehicles at wholesale used vehicle auctions. Vehicles are sold promptly upon repossession.

Financial Instruments Not Carried at Fair Value

Finance Receivables

Our finance receivables consist of retail loans and dealer financing, which is comprised of wholesale, real estate and working capital financing. Retail finance receivables are primarily valued using a securitization model that incorporates expected cash flows. Cash flows expected to be collected are estimated using contractual principal and interest payments adjusted for specific factors, such as prepayments, default rates, loss severity, credit scores, and collateral type. The securitization model utilizes quoted secondary market rates if available, or estimated market rates that incorporate management's best estimate of investor assumptions about the portfolio. The dealer financing portfolio is valued using a discounted cash flow model. Discount rates are derived based on market rates for equivalent portfolio bond ratings. As these valuations utilize unobservable inputs, our finance receivables are classified in Level 3 of the fair value hierarchy.

Commercial Paper

The carrying value of commercial paper issued is assumed to approximate fair value due to its short duration and generally negligible credit risk. We validate this assumption by recalculating the fair value of our commercial paper using quoted market rates. Commercial paper is classified in Level 2 of the fair value hierarchy.

Note 1 – Summary of Significant Accounting Policies (Continued)

Unsecured Notes and Loans Payable

Unsecured notes and loans payable are primarily valued using current market rates and credit spreads for debt with similar maturities. Our valuation models utilize observable inputs such as standard industry curves; therefore, we classify these unsecured notes and loans payables in Level 2 of the fair value hierarchy. Where observable inputs are not available, we use quoted market prices to estimate the fair value of unsecured notes and loans payable. These unsecured notes and loans payable are classified in Level 3 of the fair value hierarchy since the market for these instruments is not active. In a limited number of instances, where neither observable inputs nor quoted market prices are available, we estimate the fair value of unsecured notes and loans payable using quotes from counterparties or a third party pricing vendor. We review the appropriateness of these fair value measurements by assessing the reasonableness of period over period fluctuations. Since the valuations utilize unobservable inputs, we classify these unsecured notes and loans payable in Level 3 of the fair value hierarchy.

Secured Notes and Loans Payable

Fair value is estimated based on current market rates and credit spreads for debt with similar maturities. We also use internal assumptions, including prepayment speeds and expected credit losses on the underlying securitized assets, to estimate the timing of cash flows to be paid on these instruments. As these valuations utilize unobservable inputs, our secured notes and loans payables are classified in Level 3 of the fair value hierarchy.

Refer to Note 2 – Fair Value Measurements for additional discussion and disclosure.

Derivative Instruments

All derivative instruments are recorded on the balance sheet at fair value, taking into consideration the effects of legally enforceable master netting agreements that allow us to net settle asset and liability positions and offset cash collateral held with the same counterparty on a net basis. Changes in the fair value of derivatives are recorded in Interest expense in our Consolidated Statements of Income.

We categorize derivatives as those designated for hedge accounting (“hedge accounting derivatives”) and those that are not designated for hedge accounting (“non-hedge accounting derivatives”). At the inception of a derivative contract, we may elect to designate a derivative as a hedge accounting derivative if certain criteria are met. Hedge accounting derivatives are not widely used as a part of our risk management strategy.

Hedge Accounting Derivatives

We use derivatives to reduce the risk of changes in the fair value of debt. We occasionally designate certain derivatives as hedge accounting derivatives. In these instances, the risk being hedged is the risk of changes in the fair value of the hedged debt attributable to changes in the benchmark interest rate.

In order to qualify for hedge accounting, a derivative must be considered highly effective at reducing the risk associated with the exposure being hedged. When we designate a derivative in a hedging relationship, we contemporaneously document the risk management objective and strategy. This documentation includes the identification of the hedging instrument, the hedged item and the risk exposure, how we will assess effectiveness prospectively and retrospectively, and how often we will carry out this assessment.

We use the “long-haul” method of assessing effectiveness for our fair value hedges. Any ineffective portion of the derivative that is designated as a fair value hedge is recognized as a component of Interest expense in our Consolidated Statements of Income. We recognize changes in the fair value of derivatives designated in fair value hedging relationships (including foreign currency fair value hedging relationships) in Interest expense in our Consolidated Statements of Income along with the fair value changes of the related hedged item.

Note 1 – Summary of Significant Accounting Policies (Continued)

We review the effectiveness of our hedging relationships at least quarterly to determine whether the relationships have been and continue to be effective. We use regression analysis to assess the effectiveness of our hedges. When we determine that a hedging relationship is not or has not been effective, hedge accounting is no longer applied. If hedge accounting is discontinued, we continue to carry the derivative instrument as a component of Other assets or Other liabilities in our Consolidated Balance Sheets at fair value, with changes in fair value reported in Interest expense in our Consolidated Statements of Income. Additionally, for discontinued fair value hedges, we cease to adjust the hedged item for changes in fair value and amortize the cumulative fair value adjustments recognized in prior periods over the remaining term of the hedged item.

We will also discontinue the use of hedge accounting if a derivative is sold, terminated, or if management determines that designating a derivative under hedge accounting is no longer deemed appropriate based on current investment strategy (“de-designated derivatives”). De-designated derivatives are included within the category of non-hedge accounting derivatives.

Non-hedge accounting derivatives

Our non-hedge accounting derivatives are carried at fair value. The full change in the fair value of the derivative instrument is recognized as a component of Interest expense in our Consolidated Statements of Income with no offsetting adjustment for the economically hedged item. The derivative instrument is included as a component of Other assets or Other liabilities in our Consolidated Balance Sheets.

Embedded Derivatives

Periodically, we issue debt instruments which are considered “hybrid financial instruments”. These debt instruments are assessed to determine whether they contain embedded derivatives requiring separate accounting and reporting. The embedded derivative may be bifurcated and recorded on the balance sheet at fair value or the entire financial instrument may be recorded at fair value. As applicable, changes in the fair value of the bifurcated embedded derivative or the entire hybrid financial instrument are reported in Interest expense in our Consolidated Statements of Income. We had no embedded derivatives that required bifurcation as of March 31, 2017 and 2016.

Offsetting of Derivatives

The accounting guidance permits the net presentation on our Consolidated Balance Sheets of derivative receivables and derivative payables with the same counterparty and the related cash collateral when a legally enforceable master netting agreement exists. When we meet this condition, we elect to present such balances on a net basis.

We use master netting agreements to mitigate counterparty credit risk in derivative transactions. A master netting agreement is a contract with a counterparty that permits multiple transactions governed by that contract to be cancelled and settled with a single net balance paid to either party in the event of default or other termination event outside the normal course of business, such as a ratings downgrade of either party to the contract.

Our reciprocal collateral agreements require the transfer of cash collateral to the party in a net asset position across all transactions governed by the master netting agreement. Our collateral agreements with substantially all our counterparties include a zero threshold, full collateralization arrangement. Upon default, the collateral agreement grants the party in a net asset position the right to set-off amounts receivable against any posted collateral.

Refer to Note 7 – Derivatives, Hedging Activities and Interest Expense for additional discussion and disclosure.

Note 1 – Summary of Significant Accounting Policies (Continued)

Foreign Currency Transactions

Certain of our debt transactions are denominated in foreign currencies. If the debt is not in a designated hedge accounting relationship, the debt is translated into U.S. dollars using the applicable exchange rate at the transaction date and retranslated at each balance sheet date using the exchange rate in effect at that date. Gains and losses related to foreign currency transactions are included in Interest expense in our Consolidated Statements of Income. Payments on debt in our Consolidated Statements of Cash Flows include repayment of principal and the net amount of exchange of notional on currency swaps that economically hedge these transactions. Proceeds from issuance of debt in our Consolidated Statements of Cash Flows include both the proceeds from the initial issuance of debt and the net amount of exchange of notional on currency swaps that economically hedge these transactions.

Risk Transfer

Our insurance operations transfer certain risks to protect us against the impact of unpredictable high severity losses. The amounts recoverable from reinsurers and other companies that assume liabilities relating to our insurance operations are determined in a manner consistent with the related reinsurance or risk transfer agreement. Amounts recoverable from reinsurers and other companies on unpaid losses are recorded as a receivable but are not collectible until the losses are paid. Revenues related to risks transferred are recognized on the same basis as the related revenues from the underlying agreements. Covered losses are recorded as a reduction to insurance losses and loss adjustment expenses.

Income Taxes

We use the liability method of accounting for income taxes under which deferred tax assets and liabilities are adjusted to reflect changes in tax rates and laws in the period such changes are enacted resulting in adjustments to the current fiscal year’s provision for income taxes.

TMCC files a consolidated federal income tax return with its subsidiaries and TFSIC. TMCC files either separate or consolidated/combined state income tax returns with Toyota Motor North America, Inc. (“TMNA”), TFSIC, or subsidiaries of TMCC. State income tax expense is generally recognized as if TMCC and its subsidiaries filed their tax returns on a stand-alone basis. In those states where TMCC and its subsidiaries join in the filing of consolidated or combined income tax returns, TMCC and its subsidiaries are allocated their share of the total income tax expense based on combined allocation/apportionment factors and separate company income or loss. Based on the federal and state tax sharing agreements, TFSIC and TMCC and its subsidiaries pay for their share of the income tax expense and are reimbursed for the benefit of any of their tax losses utilized in the federal and state income tax returns.

Note 1 – Summary of Significant Accounting Policies (Continued)

New Accounting Guidance

In May 2014, the Financial Accounting Standards Board ("FASB") issued new guidance on the recognition of revenue from contracts with customers. This comprehensive standard will supersede virtually all existing revenue recognition guidance. In August 2015, the FASB issued a one-year deferral of the effective date, with early adoption as of the original effective date permitted. The FASB also subsequently issued guidance amending and clarifying various aspects of the new revenue recognition standard. We plan to adopt the new revenue guidance effective April 1, 2018 with a cumulative-effect adjustment to the current period opening balance of retained earnings. We do not expect the adoption of this standard to have a material impact on our operating lease, retail and dealer financing revenues as the majority of those revenues are outside the scope of the standard. However, certain products within our insurance operations fall within the scope of this guidance. Our evaluation of contracts related to those products identified changes to both the timing of recognition and classification of revenues and expenses. While our assessment is not complete, we do not expect these changes to have a material impact on our pretax income. We continue to assess the impact of this guidance on our consolidated financial statements and related disclosures.

In January 2016, the FASB issued new guidance that addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments and will require entities to measure equity investments at fair value and recognize any changes in fair value in earnings. This accounting guidance is effective for us on April 1, 2018. This guidance also requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from changes in instrument-specific credit risk for instruments where the entity has elected the fair value option. We are currently evaluating the potential impact of this guidance on our consolidated financial statements.

In February 2016, the FASB issued new guidance that introduces a lessee model that brings most leases on the balance sheet and aligns many of the underlying principles of the new lessor model with those in the new revenue recognition standard. The new leasing standard represents a wholesale change to lease accounting for lessees. Upon adoption, we expect to recognize lease liabilities and right-of-use assets (at their present value) in our Consolidated Balance Sheets related to predominantly all of the future minimum lease payments disclosed in Note 14 – Commitments and Contingencies. This accounting guidance is effective for us on April 1, 2019. We are continuing to evaluate the other potential impacts of this guidance on our consolidated financial statements and related disclosures.

In March 2016, the FASB issued new guidance which clarifies that a change in the counterparty to a designated derivative hedging instrument does not, in and of itself, require de-designation of that hedging relationship provided that all other hedge accounting criteria continue to be met. This accounting guidance is effective for us on April 1, 2017. The adoption of this guidance is not expected to have an impact on our consolidated financial statements.

In March 2016, the FASB issued new guidance which clarifies whether an embedded contingent put or call option is clearly and closely related to the debt host when bifurcating an embedded derivative. This accounting guidance is effective for us on April 1, 2017. The adoption of this guidance is not expected to have an impact on our consolidated financial statements.

In June 2016, the FASB issued new guidance that introduces a new impairment model based on expected losses rather than incurred losses for certain types of financial instruments. It also modifies the impairment model for available-for-sale debt securities and provides for a simplified accounting model for purchased financial assets with credit deterioration since their origination. We expect this new guidance will result in an increase in our allowance for credit losses; the magnitude of which is under evaluation. This accounting guidance is effective for us on April 1, 2020. We are currently evaluating other potential impacts of this guidance on our consolidated financial statements.

In August 2016, the FASB issued new guidance that is intended to reduce diversity in practice in the classification of certain items in the statement of cash flows. This accounting guidance is effective for us on April 1, 2018. The adoption of this guidance is not expected to have a material impact on our consolidated financial statements and related disclosures.

In October 2016, the FASB issued new guidance that further amends the analysis a reporting entity must perform to determine whether it should consolidate certain legal entities. The guidance specifically addresses interests held through related parties that are under common control. This accounting guidance is effective for us on April 1, 2017. The adoption of this guidance is not expected to have a material impact on our consolidated financial statements.

Note 1 – Summary of Significant Accounting Policies (Continued)

In November 2016, the FASB issued new guidance that clarifies how restricted cash and cash equivalents should be classified and presented in the statement of cash flows and requires new disclosures related to restricted cash and cash equivalents. This guidance was intended to reduce diversity in practice in the classification of restricted cash and cash equivalents on the statement of cash flows. This accounting guidance is effective for us on April 1, 2018 at which time we will no longer report the change in restricted cash and cash equivalents in the operating section in our Consolidated Statements of Cash Flows, and cash and cash equivalents at the beginning and end of the period will include restricted cash and cash equivalents. These changes will be applied using a retrospective transition method to each period presented.

In March 2017, the FASB issued new guidance that requires certain premiums on callable debt securities to be amortized to the earliest call date. This accounting guidance is effective for us on April 1, 2019. We are currently evaluating the potential impact of this guidance on our consolidated financial statements.

Recently Adopted Accounting Guidance

In April 2016, we adopted new FASB accounting guidance that amends the analysis a reporting entity must perform to determine whether it should consolidate certain legal entities. The adoption of this guidance did not have a material impact on our consolidated financial statements.

In April 2016, we adopted new FASB accounting guidance that requires debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability instead of being presented as an asset. As a result of adopting this guidance, we have reclassified our debt issuance costs from Other assets to Debt on our Consolidated Balance Sheets and conformed applicable footnote disclosures for all periods presented. These amounts are not material to our consolidated financial statements.

In April 2016, we adopted new FASB accounting guidance to help entities evaluate the accounting for fees paid by a customer in a cloud computing arrangement. While similar guidance existed previously under US GAAP for cloud service providers, this update provides explicit guidance for a customer's accounting. The adoption of this guidance did not have a material impact on our consolidated financial statements.

In April 2016, we adopted new FASB accounting guidance that removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. Note 2 – Fair Value Measurements has been updated, for all periods presented, to reflect the adoption of this guidance which did not have a material impact on our consolidated financial statements.

In March 2017, we adopted new FASB guidance that requires additional disclosures related to short-duration insurance contracts. The adoption of this guidance did not have an impact on our consolidated financial statements and related disclosures.