NOTE 8

FINANCIAL INSTRUMENTS AND RELATED FAIR VALUE MEASUREMENTS

Receivable Securitizations

For trade receivables originated in Japan, the company has entered into agreements with financial institutions in which the entire interest in and ownership of the receivable is sold. The company continues to service the receivables in its Japanese securitization arrangement. Servicing assets or liabilities are not recognized because the company receives adequate compensation to service the sold receivables. The Japanese securitization arrangement includes limited recourse provisions, which are not material.

The following is a summary of the activity relating to the securitization arrangement.


as of and for the years ended December 31 (in millions)	2012			2011			2010

Sold receivables at beginning of year	$	160		$	157		$	147
Proceeds from sales of receivables		630			615			557
Cash collections (remitted to the owners of the receivables)		(624	)		(622	)		(555	)
Effect of currency exchange rate changes		(9	)		10			8

Sold receivables at end of year	$	157		$	160		$	157

The net losses relating to the sales of receivables were immaterial for each year.

Concentrations of Credit Risk

The company invests excess cash in certificates of deposit or money market funds and diversifies the concentration of cash among different financial institutions. With respect to financial instruments, where appropriate, the company has diversified its selection of counterparties, and has arranged collateralization and master-netting agreements to minimize the risk of loss.

The company continues to do business with foreign governments in certain countries, including Greece, Spain, Portugal and Italy, that have experienced a deterioration in credit and economic conditions. As of December 31, 2012, the company’s net accounts receivable from the public sector in Greece, Spain, Portugal and Italy totaled $385 million (of which $66 million related to Greece). The company’s net accounts receivable from the public sector for the countries identified above decreased by $139 million during 2012 primarily as a result of the collection of past due receivables in Spain. Refer to the discussion below for information regarding the Greek government bonds previously held by the company.

Global economic conditions and liquidity issues in certain countries have resulted, and may continue to result, in delays in the collection of receivables and credit losses. Global economic conditions, governmental actions and customer-specific factors may require the company to re-evaluate the collectibility of its receivables and the company could potentially incur additional credit losses. These conditions may also impact the stability of the Euro.

Foreign Currency and Interest Rate Risk Management

The company operates on a global basis and is exposed to the risk that its earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange and interest rates. The company’s hedging policy attempts to manage these risks to an acceptable level based on the company’s judgment of the appropriate trade-off between risk, opportunity and costs.

The company is primarily exposed to foreign exchange risk with respect to recognized assets and liabilities, forecasted transactions and net assets denominated in the Euro, Japanese Yen, British Pound, Australian Dollar, Canadian Dollar, Brazilian Real, Colombian Peso and Swedish Krona. The company manages its foreign currency exposures on a consolidated basis, which allows the company to net exposures and take advantage of any natural offsets. In addition, the company uses derivative and nonderivative instruments to further reduce the net exposure to foreign exchange. Gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and equity volatility resulting from foreign exchange. Financial market and currency volatility may limit the company’s ability to cost-effectively hedge these exposures.

The company is also exposed to the risk that its earnings and cash flows could be adversely impacted by fluctuations in interest rates. The company’s policy is to manage interest costs using a mix of fixed- and floating-rate debt that the company believes is appropriate. To manage this mix in a cost-efficient manner, the company periodically enters into interest rate swaps in which the company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional amount.

The company does not hold any instruments for trading purposes and none of the company’s outstanding derivative instruments contain credit-risk-related contingent features.

Cash Flow Hedges

The company may use options, including collars and purchased options, forwards and cross-currency swaps to hedge the foreign exchange risk to earnings relating to forecasted transactions and recognized assets and liabilities. The company periodically uses forward-starting interest rate swaps and treasury rate locks to hedge the risk to earnings associated with movements in interest rates relating to anticipated issuances of debt. Certain other firm commitments and forecasted transactions are also periodically hedged. Cash flow hedges primarily related to forecasted intercompany sales denominated in foreign currencies, anticipated issuances of debt, and, prior to 2011, a hedge of U.S. Dollar-denominated debt issued by a foreign subsidiary.

The notional amounts of foreign exchange contracts were $1.5 billion as of both December 31, 2012 and 2011. In 2010, in conjunction with the maturity of $500 million of U.S. Dollar-denominated debt held by a foreign subsidiary, the company terminated cross-currency swaps that had been used to hedge this debt. The cash outflow resulting from this termination was $45 million, which was reported in the financing section of the consolidated statements of cash flows. The notional amounts of interest rate contracts designated as cash flow hedges outstanding as of December 31, 2012 and 2011 were $250 million and $200 million, respectively. In 2010, in conjunction with the 2010 debt issuance disclosed in Note 7, interest rate contracts hedging the issuance of this debt were terminated, resulting in a gain of $18 million that is being amortized to net interest expense over the life of the related debt. The maximum term over which the company has cash flow hedge contracts in place related to forecasted transactions at December 31, 2012 is 12 months.

Fair Value Hedges

The company uses interest rate swaps to convert a portion of its fixed-rate debt into variable-rate debt. These instruments hedge the company’s earnings from changes in the fair value of debt due to fluctuations in the designated benchmark interest rate.

The total notional amount of interest rate contracts designated as fair value hedges was $500 million and $675 million as of December 31, 2012 and 2011, respectively.

Dedesignations

The company terminated $175 million and $1.7 billion of interest rate contracts in 2012 and 2011, respectively, which had been designated as fair value hedges. The terminations resulted in net gains of $21 million and $121 million in 2012 and 2011, respectively, that were deferred and are being amortized as a reduction of net interest expense over the remaining terms of the underlying debt.

There were no hedge dedesignations in 2012, 2011 or 2010 resulting from changes in the company’s assessment of the probability that the hedged forecasted transactions would occur.

Undesignated Derivative Instruments

The company uses forward contracts to hedge earnings from the effects of foreign exchange relating to certain of the company’s intercompany and third-party receivables and payables denominated in a foreign currency. These derivative instruments are generally not formally designated as hedges and the terms of these instruments generally do not exceed one month.

The total notional amount of undesignated derivative instruments was $3.2 billion and $346 million as of December 31, 2012 and 2011, respectively. In December 2012, the company entered into option contracts with a total notional amount of $2.8 billion to hedge anticipated foreign currency cash outflows associated with the planned acquisition of Gambro discussed in Note 2. These contracts are not formally designated as hedges and mature in June 2013.

Gains and Losses on Derivative Instruments

The following tables summarize the gains and losses on the company’s derivative instruments for the years ended December 31, 2012 and 2011.


	Gain (loss) recognized in OCI						Location of gain (loss) in income statement		Gain (loss) reclassified from AOCI into income
(in millions)	2012			2011			Location of gain (loss) in income statement		2012			2011

Cash flow hedges
Interest rate contracts		$(10	)		$(11	)		Net interest expense		$ —			$ —
Foreign exchange contracts		(3	)		(1	)		Net sales		(3	)		(2	)
Foreign exchange contracts		—			(14	)		Cost of sales		3			(34	)

Total		$(13	)		$(26	)				$ —			$(36	)

Location of gain (loss) in
income statement

Gain (loss)
recognized in income

(in millions)

2012

2011

Fair value hedges

Interest rate contracts

Net interest expense

$11

$62

Undesignated derivative instruments

Foreign exchange contracts

Other (income) expense, net

$ (7

)

$ (6

)

For the company’s fair value hedges, equal and offsetting losses of $11 million and $62 million were recognized in net interest expense in 2012 and 2011, respectively, as adjustments to the underlying hedged items, fixed-rate debt. Ineffectiveness related to the company’s cash flow and fair value hedges for the year ended December 31, 2012 was not material.

The following table summarizes net-of-tax activity in AOCI, a component of shareholders’ equity, related to the company’s cash flow hedges.


as of and for the years ended December 31 (in millions)	2012			2011			2010

Accumulated other comprehensive income (loss) balance at beginning of year		$ 2			$ (3	)		$ 3
(Loss) gain in fair value of derivatives during the year		(7	)		(31	)		45
Amount reclassified to earnings during the year		—			36			(51	)

Accumulated other comprehensive (loss) income balance at end of year		$ (5	)		$ 2			$ (3	)

As of December 31, 2012, $1 million of deferred, net after-tax losses on derivative instruments included in AOCI are expected to be recognized in earnings during the next 12 months, coinciding with when the hedged items are expected to impact earnings.

Fair Values of Derivative Instruments

The following table summarizes the classification and fair value amounts of derivative instruments reported in the consolidated balance sheet as of December 31, 2012.


	Derivatives in asset positions			Derivatives in liability positions
(in millions)	Balance sheet location	Fair value		Balance sheet location	Fair value

Derivative instruments designated as hedges
Interest rate contracts	Other long-term assets	$	67	Accounts payable and accrued liabilities	$	21
Foreign exchange contracts	Prepaid expenses and other		28	Accounts payable and accrued liabilities		5

Total derivative instruments designated as hedges		$	95		$	26

Undesignated derivative instruments
Foreign exchange contracts	Prepaid expenses and other	$	47	Accounts payable and accrued liabilities	$	11

Total derivative instruments		$	142		$	37

The following table summarizes the classification and fair value amounts of derivative instruments reported in the consolidated balance sheet as of December 31, 2011.


	Derivatives in asset positions			Derivatives in liability positions
(in millions)	Balance sheet location	Fair value		Balance sheet location	Fair value

Derivative instruments designated as hedges
Interest rate contracts	Other long-term assets	$	77	Other long-term liabilities	$	11
Foreign exchange contracts	Prepaid expenses and other		54	Accounts payable and accrued liabilities		3
Foreign exchange contracts	Other long-term assets		1	Other long-term liabilities		—

Total derivative instruments designated as hedges		$	132		$	14

Undesignated derivative instruments
Foreign exchange contracts	Prepaid expenses and other	$	—	Accounts payable and accrued liabilities	$	1

Total derivative instruments		$	132		$	15

Fair Value Measurements

The fair value hierarchy under the accounting standard for fair value measurements consists of the following three levels:

•

Level 1 — Quoted prices in active markets that the company has the ability to access for identical assets or liabilities;

•

Level 2 — Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuations in which all significant inputs are observable in the market; and

•

Level 3 — Valuations using significant inputs that are unobservable in the market and include the use of judgment by the company’s management about the assumptions market participants would use in pricing the asset or liability.

The following tables summarize the bases used to measure financial assets and liabilities that are carried at fair value on a recurring basis in the consolidated balance sheets.


		Basis of fair value measurement
(in millions)	Balance at December 31, 2012	Quoted prices in active markets for identical assets (Level 1)	Significant other observable inputs (Level 2)	Significant unobservable inputs (Level 3)

Assets
Foreign currency hedges	$ 75	$—	$ 75	$—
Interest rate hedges	67	—	67	—
Available-for-sale securities
Equity securities	15	15	—	—
Preferred stock	51	—	—	51
Foreign government debt securities	16	—	16	—

Total assets	$224	$15	$158	$51

Liabilities
Foreign currency hedges	$ 16	$—	$ 16	$—
Interest rate hedges	21	—	21	—
Contingent payments related to acquisitions and investments	86	—	—	86

Total liabilities	$123	$—	$ 37	$86


		Basis of fair value measurement
(in millions)	Balance at December 31, 2011	Quoted prices in active markets for identical assets (Level 1)	Significant other observable inputs (Level 2)	Significant unobservable inputs (Level 3)

Assets
Foreign currency hedges	$ 55	$—	$ 55	$ —
Interest rate hedges	77	—	77	—
Available-for-sale securities
Equity securities	21	21	—	—

Total assets	$153	$21	$132	$ —

Liabilities
Foreign currency hedges	$ 4	$—	$ 4	$ —
Interest rate hedges	11	—	11	—
Contingent payments related to acquisitions and investments	234	—	—	234

Total liabilities	$249	$—	$ 15	$234

As of December 31, 2012, cash and equivalents of $3.3 billion included money market funds of approximately $1.0 billion, which would be considered Level 2 in the fair value hierarchy.

For assets that are measured using quoted prices in active markets, the fair value is the published market price per unit multiplied by the number of units held, without consideration of transaction costs. The majority of the derivatives entered into by the company are valued using internal valuation techniques as no quoted market prices exist for such instruments. The principal techniques used to value these instruments are discounted cash flow and Black-Scholes models. The key inputs are considered observable and vary depending on the type of derivative, and include contractual terms, interest rate yield curves, foreign exchange rates and volatility. The fair values of foreign government debt securities are obtained from pricing services or broker/dealers who use proprietary pricing applications, which include observable market information for like or same securities. The preferred stock is valued based upon recent transactions, as well as the financial information of the investee. The contingent payments are valued using a discounted cash flow technique that reflects management’s expectations about probability of payment, which can range from 0 to 100 percent. Significant increases or decreases in the probability of payment would result in an increase or decrease, respectively, in the fair value. The weighted-average probability used as of December 31, 2012 was approximately 60%.

At December 31, 2012, the company held available-for-sale equity securities that had an amortized cost basis and fair value of $13 million and $15 million, respectively, with $2 million of cumulative unrealized gains. At December 31, 2011, the amortized cost basis and fair value of the available-for-sale equity securities was $14 million and $21 million, respectively, with $7 million in cumulative unrealized gains.

In July 2012, Baxter acquired approximately 3 million shares of Onconova preferred stock for $50 million. The preferred stock included a redemption right for Baxter and the company has classified the investment as an available-for-sale debt security. In March 2012, the company’s Greek government debt holdings were restructured into new Greek government bonds with a notional amount of $24 million ranging in maturity from 11 to 30 years, and European Financial Stability Facility (EFSF) bonds with a notional amount of $11 million maturing in one to two years. In the first quarter of 2012, the company recorded a loss of $5 million in other (income) expense, net related to the write-down of the fair value of the original Greek government bonds of $21 million to the fair value of the new bonds of $16 million. In the second quarter of 2012, the company sold all of its Greek government and EFSF bond holdings, from which the company received $14 million in proceeds and recognized a realized loss of $3 million in other (income) expense, net.

In February 2012, as a result of the company’s acquisition of Synovis, the company acquired marketable securities, which included municipal securities, corporate bonds, and U.S. government agency issues, which had been classified as available-for-sale, with primarily all of these securities maturing within one year. The company received proceeds of $45 million from the sale and maturity of all of these securities in 2012.

As of December 31, 2012, the cumulative unrealized gains for the company’s available-for-sale debt securities were less than $1 million.

Refer to Note 11 for fair value disclosures related to the company’s pension plans.

The following table is a reconciliation of the fair value measurements that use significant unobservable inputs (Level 3), which consist of contingent payments related to acquisitions and investments and preferred stock.


(in millions)	Contingent payments			Preferred stock

Fair value as of December 31, 2010		$ 125			$—
Additions, net of payments of $13		102			—
Loss recognized in earnings		7			—

Fair value as of December 31, 2011		234			—
Purchases		—			50
Payments		(40	)		—
Gains recognized in earnings		(108	)		—
CTA		—			1

Fair value as of December 31, 2012		$ 86			$51

The company’s payments in 2012 principally related to milestones associated with the SIGMA agreement. As discussed in Note 4, the gains recognized in earnings in 2012 included $53 million and $38 million related to the reduction of the contingent payment liabilities for certain milestones associated with the 2011 acquisition of Prism and the 2010 acquisition of ApaTech, respectively. These gains were reported in other (income) expense, net. The contingent liabilities were reduced based on updated information indicating that the probability of achieving certain milestones was lower than previously expected.

The loss recognized in earnings in 2011 related to liabilities held at December 31, 2011 and was reported in cost of sales and R&D expenses. The additions during 2011 principally related to the fair value of contingent payments associated with the company’s acquisition of Prism and the arrangement with Ceremed, Inc. (Ceremed) related to Ceremed’s OSTENE brand bone hemostasis product line, as well as its AOC PolymerBlend technology, which is used in manufacturing Baxter’s ACTIFUSE product, a silicate substituted calcium phosphate synthetic bone graft material. Refer to Note 4 for more information regarding the Prism acquisition.

As discussed further in Note 6, the company recorded asset impairment charges related to its COLLEAGUE and SYNDEO infusion pumps and business optimization initiatives in 2012, 2011, and 2010. As these assets had no alternative use and no salvage value, the fair values, measured using significant unobservable inputs (Level 3), were assessed to be zero.

Book Values and Fair Values of Financial Instruments

In addition to the financial instruments that the company is required to recognize at fair value on the consolidated balance sheets, the company has certain financial instruments that are recognized at historical cost or some basis other than fair value. For these financial instruments, the following table provides the values recognized on the consolidated balance sheets and the approximate fair values.


	Book values				Approximate fair values
as of December 31 (in millions)	2012		2011		2012		2011

Assets
Long-term insurance receivables	$	2	$	15	$	2	$	15
Investments		46		85		49		94
Liabilities
Short-term debt		27		256		27		256
Current maturities of long-term debt and lease obligations		323		190		324		190
Long-term debt and lease obligations		5,580		4,749		6,201		5,312
Long-term litigation liabilities		32		63		31		62

The following table summarizes the bases used to measure the approximate fair value of the financial instruments as of December 31, 2012.


		Basis of fair value measurement
(in millions)	Balance as of December 31, 2012	Quoted prices in active markets for identical assets (Level 1)	Significant other observable inputs (Level 2)	Significant unobservable inputs (Level 3)

Assets
Long-term insurance receivables	$ 2	$—	$ 2	$—
Investments	49	—	19	30

Total assets	$ 51	$—	$ 21	$30

Liabilities
Short-term debt	$ 27	$—	$ 27	$—
Current maturities of long-term debt and lease obligations	324	—	324	—
Long-term debt and lease obligations	6,201	—	6,201	—
Long-term litigation liabilities	31	—	31	—

Total liabilities	$6,583	$—	$6,583	$—

The estimated fair values of long-term insurance receivables and long-term litigation liabilities were computed by discounting the expected cash flows based on currently available information, which in many cases does not include final orders or settlement agreements. The discount factors used in the calculations reflect the non-performance risk of the insurance providers and the company, respectively.

Investments in 2012 principally included certain cost method investments and held-to-maturity debt securities. The decrease in investments in 2012 primarily related to the first quarter 2012 restructuring of the company’s Greek government bonds and subsequent classification as available-for-sale, as discussed above, and the sale of the company’s common stock investment in Enobia Pharma Corporation (Enobia), which the company originally purchased in 2011. An $18 million investment was made in 2011 in the common stock of Enobia, a privately-held company that develops therapies to treat serious genetic bone disorders for which there are no approved treatments, which had been classified as a cost method investment. In determining the fair value of cost method investments, the company had taken into consideration recent transactions, as well as the financial information of the investee.

Investments in 2011 principally included held-to-maturity debt securities, as well as certain cost method investments. In 2011, certain past due receivables with the Greek government were converted into non-interest bearing bonds with maturities of one to three years. In December 2011, the company collected $17 million upon the maturity of the first tranche of the bonds, which is reported in the investing section of the consolidated statement of cash flows. However, as a result of continued economic uncertainty and ongoing Greek government negotiations regarding the settlement terms for outstanding bonds, the company recorded an impairment charge of $41 million in the fourth quarter of 2011 to reduce the remaining Greek government bonds to estimated fair value, which is reported in other (income) expense, net. The estimated fair value of these bonds was calculated using a discounted cash flow model that incorporated observable inputs, including interest rate yields. As of December 31, 2011, these bonds had both a book value and fair value of $21 million.

The fair value of held-to-maturity debt securities is calculated using a discounted cash flow model that incorporates observable inputs, including interest rate yields, which represents a Level 2 basis of fair value measurement. In determining the fair value of cost method investments, the company takes into consideration recent transactions, as well as the financial information of the investee, which represents a Level 3 basis of fair value measurement.

The estimated fair values of current and long-term debt were computed by multiplying price by the notional amount of the respective debt instrument. Price is calculated using the stated terms of the respective debt instrument and yield curves commensurate with the company’s credit risk. The carrying values of the other financial instruments approximate their fair values due to the short-term maturities of most of these assets and liabilities.