9. DEBT, FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Debt Issuance

In May 2017, Baxter issued senior notes with a total aggregate principal amount of €600 million at a fixed coupon rate of 1.30% due in May 2025. The company has designated this debt as a non-derivative net investment hedge of its European operations for accounting purposes.

Securitization arrangement

The following is a summary of the activity relating to the company’s securitization arrangement in Japan.

	Three months ended June 30,						Six months ended June 30,
(in millions)	2018			2017			2018			2017
Sold receivables at beginning of period	$	64		$	61		$	71		$	68
Proceeds from sales of receivables		67			67			129			129
Cash collections (remitted to the owners of the receivables)		(65	)		(66	)		(136	)		(137	)
Effect of currency exchange rate changes		(2	)		1			-			3
Sold receivables at end of period	$	64		$	63		$	64		$	63

The impacts on the condensed consolidated statements of income relating to the sale of receivables were immaterial for each period. Refer to the 2017 Annual Report for further information regarding the company’s securitization agreements.

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 June 30, 2018, the company’s net accounts receivable from the public sector in Greece, Spain, Portugal and Italy totaled $133 million.

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. Governmental actions and customer-specific factors may also require the company to re-evaluate the collectability of its receivables and the company could potentially incur additional credit losses. These conditions may also impact the stability of the Euro.

Derivatives and hedging activities

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, British Pound, Chinese Yuan, Korean Won, Australian Dollar, Canadian Dollar, Japanese Yen, Colombian Peso, Brazilian Real, Mexican Peso and New Zealand Dollar. 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.

All derivative instruments are recognized as either assets or liabilities at fair value in the condensed consolidated balance sheets and are classified as short-term or long-term based on the scheduled maturity of the instrument. Based upon the exposure being hedged, the company designates its hedging instruments as cash flow, fair value, or net investment hedges.

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.

For each derivative instrument that is designated and effective as a cash flow hedge, the gain or loss on the derivative is accumulated in accumulated other comprehensive income (AOCI) and then recognized in earnings consistent with the underlying hedged item. Option premiums or net premiums paid are initially recorded as assets and reclassified to other comprehensive income (OCI) over the life of the option, and then recognized in earnings consistent with the underlying hedged item. Cash flow hedges are classified in net sales, cost of sales, net interest expense, and other (income) expense, net, and primarily relate to forecasted third-party sales denominated in foreign currencies, forecasted intercompany sales denominated in foreign currencies, and anticipated issuances of debt, respectively.

The notional amounts of foreign exchange contracts were $636 million and $660 million as of June 30, 2018 and December 31, 2017, respectively. There were no outstanding interest rate contracts designated as cash flow hedges as of June 30, 2018 and December 31, 2017. The maximum term over which the company has cash flow hedge contracts in place related to forecasted transactions as of June 30, 2018 is 15 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. For each derivative instrument that is designated and effective as a fair value hedge, the gain or loss on the derivative is recognized immediately to earnings, and offsets the loss or gain on the underlying hedged item. Fair value hedges are classified in net interest expense, as they hedge the interest rate risk associated with certain of the company’s fixed-rate debt.

There were no outstanding interest rate swap contracts designated as a fair value hedge as of June 30, 2018. The total notional amount of interest rate contracts designated as fair value hedges was $200 million as of December 31, 2017.

Net Investment Hedges

In May 2017, the company issued €600 million of senior notes due May 2025. The company has designated this debt as a hedge of a portion of its net investment in its European operations and, as a result, mark to spot rate adjustments of the outstanding debt balances have been and will be recorded as a component of AOCI. As of June 30, 2018, the company had an accumulated pre-tax unrealized translation loss in AOCI of $62 million related to the Euro-denominated senior notes.

Dedesignations

If it is determined that a derivative or nonderivative hedging instrument is no longer highly effective as a hedge, the company discontinues hedge accounting prospectively. If the company removes the cash flow hedge designation because the hedged forecasted transactions are no longer probable of occurring, any gains or losses are immediately reclassified from AOCI to earnings. Gains or losses relating to terminations of effective cash flow hedges in which the forecasted transactions are still probable of occurring are deferred and recognized consistent with the loss or income recognition of the underlying hedged items.

There were no hedge dedesignations in the first six months of 2018 or 2017 resulting from changes in the company’s assessment of the probability that the hedged forecasted transactions would occur.

If the company terminates a fair value hedge, an amount equal to the cumulative fair value adjustment to the hedged items at the date of termination is amortized to earnings over the remaining term of the hedged item. In the first six months of 2018, the company terminated its interest rate fair value hedges and the cumulative fair value adjustment to the hedged item was insignificant. There were no fair value hedges terminated during the first six months of 2017.

If the company terminates a net investments hedge, any gain or loss recognized in AOCI is not reclassified to earnings until the company sells, liquidates, or deconsolidates the foreign investments that were being hedged.

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 change in fair value, which substantially offsets the change in book value of the hedged items, is recorded directly to other (income) expense, net. The terms of these instruments generally do not exceed one month.

The total notional amount of undesignated derivative instruments was $655 million as of June 30, 2018 and $885 million as of December 31, 2017.

Gains and Losses on Hedging Activities

The following tables summarize the income statement locations and gains and losses on the company’s derivative instruments for the three months ended June 30, 2018 and 2017.

	Gain (loss) recognized in OCI					Location of gain (loss)	Gain (loss) reclassified from AOCI into income
(in millions)	2018		2017			in income statement	2018			2017
Cash flow hedges
Foreign exchange contracts	$	7	$	(5	)	Cost of sales	$	(6	)	$	(3	)
Interest Rate contracts		—		(3	)	Net interest expense		—			—
Net investment hedge		38	$	(31	)	Other (income) expense, net		—			—
Total	$	45	$	(39	)		$	(6	)	$	(3	)

		Gain (loss) recognized in income
(in millions)	Location of gain (loss) in income statement	2018		2017
Fair value hedges
Interest rate contracts	Net interest expense	$	—	$	1
Undesignated derivative instruments
Foreign exchange contracts	Other (income) expense, net	$	6	$	(4	)

The following tables summarize the income statement locations and gains and losses on the company’s derivative instruments for the six months ended June 30, 2018 and 2017.

	Gain (loss) recognized in OCI						Location of gain (loss)	Gain (loss) reclassified from AOCI into income
(in millions)	2018			2017			in income statement	2018			2017
Cash flow hedges
Foreign exchange contracts	$	(2	)	$	(13	)	Cost of sales	$	(10	)	$	(1	)
Interest Rate contracts		—			(3	)	Net interest expense		—			—
Net investment hedge		17		$	(31	)	Other (income) expense, net		—			—
Total	$	15		$	(47	)		$	(10	)	$	(1	)

		Gain (loss) recognized in income
(in millions)	Location of gain (loss) in income statement	2018			2017
Fair value hedges
Interest rate contracts	Net interest expense	$	(4	)	$	—
Undesignated derivative instruments
Foreign exchange contracts	Other (income) expense, net	$	(11	)	$	(4	)

For the company’s fair value hedges, equal and offsetting gains of zero and $4 million were recognized in net interest expense in the second quarter and first half of 2018, respectively and an equal and offsetting loss of $1 million was recognized in net interest expense in the second quarter of 2017. Ineffectiveness related to the company’s cash flow and fair value hedges for all periods presented were not material.

As of June 30, 2018, $2 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 values of derivative instruments reported in the condensed consolidated balance sheet as of June 30, 2018.

	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
Foreign exchange contracts	Prepaid expenses and other	$	17	Accounts payable and accrued liabilities	$	2
Total derivative instruments designated as hedges		$	17		$	2
Undesignated derivative instruments
Foreign exchange contracts	Prepaid expenses and other	$	—	Accounts payable and accrued liabilities	$	1
Total derivative instruments		$	17		$	3

The following table summarizes the classification and fair values of derivative instruments reported in the condensed consolidated balance sheet as of December 31, 2017.

	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	$	4	Other long- term liabilities	$	—
Foreign exchange contracts	Prepaid expenses and other		14	Accounts payable and accrued liabilities		3
Total derivative instruments designated as hedges		$	18		$	3
Undesignated derivative instruments
Foreign exchange contracts	Prepaid expenses and other	$	1	Accounts payable and accrued liabilities	$	1
Total derivative instruments		$	19		$	4

While the company’s derivatives are all subject to master netting arrangements, the company presents its assets and liabilities related to derivative instruments on a gross basis within the condensed consolidated balance sheets. Additionally, the company is not required to post collateral for any of its outstanding derivatives.

The following table provides information on the company’s derivative positions as if they were presented on a net basis, allowing for the right of offset by counterparty.

	June 30, 2018						December 31, 2017
(in millions)	Asset			Liability			Asset			Liability
Gross amounts recognized in the consolidated balance sheet	$	17		$	3		$	19		$	4
Gross amount subject to offset in master netting arrangements not offset in the consolidated balance sheet		(3	)		(3	)		(4	)		(4	)
Total	$	14		$	—		$	15		$	—

Fair value measurements

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 condensed consolidated balance sheets.

			Basis of fair value measurement
(in millions)	Balance as of June 30, 2018		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	$	17	$	—	$	17	$	—
Marketable equity securities		13		6		7		—
Total assets	$	30	$	6	$	24	$	—
Liabilities
Foreign currency hedges	$	3	$	—	$	3	$	—
Contingent payments related to acquisitions		23		—		—		23
Total liabilities	$	26	$	—	$	3	$	23

			Basis of fair value measurement
(in millions)	Balance as of December 31, 2017		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	$	15	$	—	$	15	$	—
Interest rate hedges		4		—		4		—
Marketable equity securities		8		8		—		—
Total assets	$	27	$	8	$	19	$	—
Liabilities
Foreign currency hedges	$	4	$	—	$	4	$	—
Contingent payments related to acquisitions		9		—		—		9
Total liabilities	$	13	$	—	$	4	$	9

As of June 30, 2018, cash and equivalents of $2.9 billion included money market funds of approximately $1.2 billion, and as of December 31, 2017, cash and equivalents of $3.4 billion included money market funds of approximately $0.7 billion. Money market funds are 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.

Contingent payments related to acquisitions consist of milestone payments and sales-based payments, and are valued using discounted cash flow techniques. The fair value of milestone payments reflects management’s expectations of probability of payment, and increases as the probability of payment increases or expectation of timing of payments is accelerated. The fair value of sales-based payments is based upon probability-weighted future revenue estimates, and increases as revenue estimates increase, probability weighting of higher revenue scenarios increase or expectation of timing of payment is accelerated. The change in the liability for contingent payments related to Baxter’s acquisitions, which use significant unobservable inputs (Level 3) in the fair value measurement, were primarily driven by new contingent liabilities recognized as a result of the RECOTHROM and PREVELEAK acquisitions of approximately $14 million in the first half of 2018.

Equity investments not measured at fair value and excluded from the above table are comprised of other equity investments without readily determinable fair values of $36 million at June 30, 2018 and $43 million at December 31, 2017. These amounts are included in Other assets.

The following table provides information relating to the company’s investments in marketable equity securities.

(in millions)	Amortized cost		Unrealized gains		Unrealized losses		Fair value
June 30, 2018	$	11	$	3	$	1	$	13
December 31, 2017	$	8	$	—	$	—	$	8

In the first quarter of 2017, the company recorded an other-than-temporary impairment charge related to a marketable equity security of $4 million within other (income) expense, net.

Book Values and Fair Values of Financial Instruments

In addition to the financial instruments that the company is required to recognize at fair value in the condensed 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 in the condensed consolidated balance sheets and the approximate fair values as of June 30, 2018 and December 31, 2017.

	Book values				Approximate fair values
(in millions)	2018		2017		2018		2017
Liabilities
Current maturities of long-term debt and lease obligations	$	3	$	3	$	3	$	3
Long-term debt and lease obligations		3,495		3,509		3,479		3,595

The following tables summarize the bases used to measure the approximate fair value of the financial instruments as of June 30, 2018 and December 31, 2017.

			Basis of fair value measurement
(in millions)	Balance as of June 30, 2018		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Liabilities
Current maturities of long-term debt and lease obligations	$	3	$	—	$	3	$	—
Long-term debt and lease obligations		3,479		—		3,479		—
Total liabilities	$	3,482	$	—	$	3,482	$	—

			Basis of fair value measurement
(in millions)	Balance as of December 31, 2017		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Liabilities
Current maturities of long-term debt and lease obligations	$	3	$	—	$	3	$	—
Long-term debt and lease obligations		3,595		—		3,595		—
Total liabilities	$	3,598	$	—	$	3,598	$	—

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.