Cummins Inc. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

DERIVATIVES

DERIVATIVES

12 Months Ended

Dec. 31, 2023

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments and Hedging Activities Disclosure

NOTE 21. DERIVATIVES

We are exposed to financial risk resulting from volatility in foreign exchange rates, interest rates and commodity prices. This risk is closely monitored and managed through the use of physical forward contracts (which are not considered derivatives) and financial derivative instruments including foreign currency forward contracts, commodity swap contracts and interest rate swaps and locks. Financial derivatives are used expressly for hedging purposes and under no circumstances are they used for speculative purposes. When material, we adjust the estimated fair value of our derivative contracts for counterparty or our credit risk. None of our derivative instruments are subject to collateral requirements. Substantially all of our derivative contracts are subject to master netting arrangements, which provide us with the option to settle certain contracts on a net basis when they settle on the same day with the same currency. In addition, these arrangements provide for a net settlement of all contracts with a given counterparty in the event that the arrangement is terminated due to the occurrence of default or a termination event.

Foreign Currency Exchange Rate Risk

We had foreign currency forward contracts with notional amounts of $4.5 billion at December 31, 2023, with the following currencies comprising 85 percent of outstanding foreign currency forward contracts: British pound, Chinese renminbi, Canadian dollar, Australian dollar and Swedish kronor. We had foreign currency forward contracts with notional amounts of $3.6 billion at December 31, 2022, with the following currencies comprising 88 percent of outstanding foreign currency forward contracts: Chinese renminbi, British pound, Canadian dollar, Australian dollar and Euro.

We are further exposed to foreign currency exchange risk as many of our subsidiaries are subject to fluctuations as the functional currencies of the underlying entities are not our U.S. dollar reporting currency. To help minimize movements for certain investments, in the third quarter of 2022 we began entering into foreign exchange forwards designated as net investment hedges for certain of our investments. Under the current terms of our foreign exchange forwards, we agreed with third parties to sell British pound in exchange for U.S. dollar currency at a specified rate at the maturity of the contract. The notional amount of these hedges at December 31, 2023, was $808 million.

The following table summarizes the net investment hedge activity in AOCL:


	Years ended December 31,
In millions	2023		2022
Type of Derivative	Gain (Loss) Recognized in AOCL		Gain (Loss) Reclassified from AOCL into Earnings		Gain (Loss) Recognized in AOCL		Gain (Loss) Reclassified from AOCL into Earnings

Foreign exchange forwards	$	(30)	$	—	$	(22)	$	—

Interest Rate Risk

In September 2023, we entered into a series of interest rate swaps with a total notional value of $500 million in order to trade a portion of the floating rate into a fixed rate on our term loan, due in 2025. The maturity date of the interest rate swaps is August 1, 2025. The weighted-average interest rate of the interest rate swaps is 5.72 percent. We designated the swaps as cash flow hedges. The gains and losses on these derivative instruments are initially recorded in other comprehensive income and reclassified into earnings as interest expense in the Consolidated Financial Statements as each interest payment is accrued.

The following table summarizes the interest rate swap activity in AOCL:


	Year ended December 31,
In millions	2023
Type of Swap	Gain (Loss) Recognized in AOCL		Gain (Loss) Reclassified from AOCL into Interest Expense
Interest rate swaps	$	(4)	$	—

In 2021, we entered into a series of interest rate swaps to effectively convert our $500 million senior notes, due in 2025, from a fixed rate of 0.75 percent to a floating rate equal to the three-month LIBOR plus a spread. We also entered into a series of interest rate swaps to effectively convert $765 million of our $850 million senior notes, due in 2030, from a fixed rate of 1.50 percent to a floating rate equal to the three-month LIBOR plus a spread. The fallback protocol in our derivative agreements allowed for a transition from LIBOR to SOFR in the third quarter of 2023. We designated the swaps as fair value hedges. The gain or loss on these derivative instruments, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk, are recognized in current income

as interest expense. The net swap settlements that accrue each period are also reported in the Consolidated Financial Statements as interest expense. In March 2023, we settled a portion of our 2021 interest rate swaps with a notional amount of $100 million. The $7 million loss on settlement will be amortized over the remaining term of the related debt.

The following table summarizes the gains and losses:


	Years ended December 31,
In millions	2023				2022			2021
Type of Swap	Gain (Loss) on Swaps		Gain (Loss) on Borrowings			Gain (Loss) on Swaps		Gain (Loss) on Borrowings		Gain (Loss) on Swaps		Gain (Loss) on Borrowings
Interest rate swaps (1)	$	31	$	(32)		$	(148)	$	145	$	(3)	$	2

(1) The difference between the gain (loss) on swaps and borrowings represented hedge ineffectiveness.

In 2019, we entered into $350 million of interest rate lock agreements, and in 2020 we entered into an additional $150 million of lock agreements to reduce the variability of the cash flows of the interest payments on a total of $500 million of fixed rate debt originally forecast to be issued in 2023 to replace our senior notes at maturity. The terms of the rate locks mirror the time period of the expected fixed rate debt issuance and the expected timing of interest payments on that debt. The gains and losses on these derivative instruments are initially recorded in other comprehensive income and will be released to earnings in interest expense in future periods to reflect the difference in (1) the fixed rates economically locked in at the inception of the hedge and (2) the actual fixed rates established in the debt instrument at issuance. In 2022, we settled certain rate lock agreements with notional amounts totaling $150 million for $49 million in cash. In 2023, we settled all remaining rate lock agreements with notional amounts totaling $350 million for $101 million. The majority of the $150 million of gains on settlements will remain in other comprehensive income and will be amortized over the term of the debt anticipated to be issued in early 2024. The following table summarizes the interest rate lock activity in AOCL:


	Year ended December 31,
In millions	2023		2022				2021
Type of Swap	Gain (Loss) Recognized in AOCL		Gain (Loss) Reclassified from AOCL into Interest Expense		Gain (Loss) Recognized in AOCL			Gain (Loss) Reclassified from AOCL into Interest Expense		Gain (Loss) Recognized in AOCL		Gain (Loss) Reclassified from AOCL into Interest Expense

Interest rate locks	$	14	$	2	$	112		$	—	$	19	$	—

Cash Flow Hedging

The following table summarizes the effect on our Consolidated Statements of Net Income for derivative instruments classified as cash flow hedges. The table does not include amounts related to ineffectiveness as it was not material for the periods presented.


	Years ended December 31,
In millions	2023		2022		2021
Gain (loss) reclassified from AOCL into income - Net sales (1)	$	17	$	(4)	$	(4)
Gain reclassified from AOCL into income - Cost of sales (1)(2)	3		1		6



(1) Includes foreign currency forward contracts.
(2) Includes commodity swap contracts.

Derivatives Not Designated as Hedging Instruments

The following table summarizes the effect on our Consolidated Statements of Net Income for derivative instruments not designated as hedging instruments:


	Years ended December 31,
In millions	2023		2022		2021
(Loss) gain recognized in income - Cost of sales (1)	$	(3)	$	2	$	—
(Loss) gain recognized in income - Other income, net (1)	(21)		(5)		45


(1) Includes foreign currency forward contracts.

Fair Value Amount and Location of Derivative Instruments

The following table summarizes the location and fair value of derivative instruments on our Consolidated Balance Sheets:


	Derivatives Designated as Hedging Instruments				Derivatives Not Designated as Hedging Instruments
	December 31,				December 31,
In millions	2023		2022		2023		2022
Notional amount	$	2,997	$	3,051	$	3,610	$	2,900

Derivative assets
Prepaid expenses and other current assets	$	14	$	18	$	16	$	27

Other assets	—		80		—		—
Total derivative assets (1)	$	14	$	98	$	16	$	27

Derivative liabilities
Other accrued expenses	$	43	$	19	$	14	$	3
Other liabilities	117		151		—		—
Total derivative liabilities (1)	$	160	$	170	$	14	$	3

(1) Estimates of the fair value of all derivative assets and liabilities above are derived from Level 2 inputs, which are estimated using actively quoted prices for similar instruments from brokers and observable inputs where available, including market transactions and third-party pricing services, or net asset values provided to investors. We do not currently have any Level 3 input measures and there were no transfers into or out of Level 2 or 3 during 2023 or 2022.

We elected to present our derivative contracts on a gross basis in our Consolidated Balance Sheets. Had we chosen to present on a net basis, we would have derivatives in a net asset position of $4 million and $52 million and derivatives in a net liability position of $148 million and $100 million at December 31, 2023, and 2022, respectively.