Note 10. FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Financial instruments include cash and cash equivalents, marketable securities, accounts receivable and payable, debt instruments and derivatives.

Changes in exchange rates and interest rates create exposure to market risk. Certain derivative financial instruments are used when available on a cost-effective basis to hedge the underlying economic exposure. These instruments qualify as cash flow, net investment and fair value hedges upon meeting certain criteria, including effectiveness of offsetting hedged exposures. Changes in fair value of derivatives that do not qualify for hedge accounting are recognized in earnings as they occur. Derivative financial instruments are not used for trading purposes.

Financial instruments are subject to counterparty credit risk which is considered as part of the overall fair value measurement. Counterparty credit risk is monitored on an ongoing basis and mitigated by limiting amounts outstanding with any individual counterparty, utilizing conventional derivative financial instruments and only entering into agreements with counterparties that meet high credit quality standards. The consolidated financial statements would not be materially impacted if any counterparty failed to perform according to the terms of its agreement. Collateral is not required by any party whether derivatives are in an asset or liability position under the terms of the agreements.

Fair Value Measurements – The fair values of financial instruments are classified into one of the following categories:

Level 1 inputs utilize non-binding quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical assets or liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs. These instruments include U.S. treasury securities.

Level 2 inputs utilize observable prices for similar instruments, non-binding quoted prices for identical or similar instruments in markets that are not active, and other observable inputs that can be corroborated by market data for substantially the full term of the assets or liabilities. These instruments include corporate debt securities, certificates of deposit, money market funds, foreign currency forward contracts, interest rate swap contracts, equity funds, fixed income funds and long-term debt. Additionally, certain corporate debt securities utilize a third-party matrix pricing model that uses significant inputs corroborated by market data for substantially the full term of the assets. Equity and fixed income funds are primarily invested in publicly traded securities and are valued at the respective net asset value of the underlying investments. There were no significant unfunded commitments or restrictions on redemptions related to equity and fixed income funds as of December 31, 2013. Level 2 derivative instruments are valued using London Interbank Offered Rate (LIBOR) yield curves, less credit valuation adjustments, and observable forward foreign exchange rates at the reporting date. Valuations of derivative contracts may fluctuate considerably from period-to-period due to volatility in underlying foreign currencies and underlying interest rates, which are driven by market conditions and the duration of the contract. Credit adjustment volatility may have a significant impact on the valuation of interest rate swaps due to changes in counterparty credit ratings and credit default swap spreads.

Level 3 unobservable inputs are used when little or no market data is available. The fair value of written options to sell the assets of certain businesses in connection with alliance agreements (see “—Note 3. Alliances” for further discussion) is based on an option pricing methodology that considers revenue and profitability projections, volatility, discount rates, and potential exercise price assumptions.The fair value of contingent consideration related to an acquisition (See "—Note 4. Acquisitions") was estimated utilizing a model that considered the probability of achieving each milestone and discount rates. Valuation models for the Auction Rate Security (ARS) and Floating Rate Security (FRS) portfolio are based on expected cash flow streams and collateral values including assessments of counterparty credit quality, default risk underlying the security, discount rates and overall capital market liquidity. The fair value of the ARS and FRS was not material at December 31, 2013 and 2012.

Financial assets and liabilities measured at fair value on a recurring basis are summarized below:



	December 31, 2013											December 31, 2012
Dollars in Millions	Level 1		Level 2			Level 3			Total			Level 1		Level 2			Level 3			Total
Cash and cash equivalents - Money market and other securities	$	—	$	3,201		$	—		$	3,201		$	—	$	1,288		$	—		$	1,288
Marketable securities
Certificates of deposit	—		122			—			122			—		34			—			34
Corporate debt securities	—		4,432			—			4,432			—		4,377			—			4,377
U.S. Treasury securities	—		—			—			—			150		—			—			150
Equity funds	—		74			—			74			—		57			—			57
Fixed income funds	—		46			—			46			—		47			—			47
ARS and FRS	—		—			12			12			—		—			31			31
Derivative assets:
Interest rate swap contracts	—		64			—			64			—		146			—			146
Foreign currency forward contracts	—		50			—			50			—		59			—			59
Derivative liabilities:
Interest rate swap contracts	—		(27		)	—			(27		)	—		—			—			—
Foreign currency forward contracts	—		(35		)	—			(35		)	—		(30		)	—			(30		)
Written option liabilities^(a)	—		—			(162		)	(162		)	—		—			(18		)	(18		)
Contingent consideration liability^(b)	—		—			(8		)	(8		)	—		—			(8		)	(8		)


(a)	Written option liabilities of $18 million and $144 million are included in accrued expenses and other liabilities, respectively. See "Note 3. Alliances" for further information.


(b)	The contingent consideration liability is included in other liabilities. See "Note 4. Acquisitions" for further information.

The following table summarizes the activity the financial assets utilizing Level 3 fair value measurements:



	2013									2012
Dollars in Millions	Written option liabilities			Contingent consideration liability			ARS and FRS			Written option liabilities			Contingent consideration liability			ARS and FRS
Fair value at January 1	$	(18	)	$	(8	)	$	31		$	—		$	(8	)	$	110
Additions from new alliances	(144		)	—			—			(18		)	—			—
Unrealized gains	—			—			1			—			—			2
Sales	—			—			(20		)	—			—			(81		)
Fair value at December 31	$	(162	)	$	(8	)	$	12		$	(18	)	$	(8	)	$	31

Available-for-sale Securities

The following table summarizes available-for-sale securities:



Dollars in Millions	Amortized Cost		Gross Unrealized Gain in Accumulated OCI		Gross Unrealized Loss in Accumulated OCI			Fair Value
Dollars in Millions	Amortized Cost		Gross Unrealized Gain in Accumulated OCI		Gross Unrealized Loss in Accumulated OCI			Fair Value
December 31, 2013
Certificates of deposit	$	122	$	—	$	—		$	122
Corporate debt securities	4,401		44		(13		)	4,432
ARS	9		3		—			12
Total	4,532		47		(13		)	4,566

December 31, 2012
Certificates of deposit	$	34	$	—	$	—		$	34
Corporate debt securities	4,305		72		—			4,377
U.S. Treasury securities	150		—		—			150
ARS and FRS	29		3		(1		)	31
Total	4,518		75		(1		)	4,592

Available-for-sale securities included in current marketable securities were $819 million at December 31, 2013. Non-current available-for-sale corporate debt securities maturing within five years were $3,735 million at December 31, 2013. Auction rate securities maturing beyond 10 years were $12 million at December 31, 2013.

Fair Value Option for Financial Assets

The Company invests in equity and fixed income funds that are designed to offset the changes in fair value of certain employee retirement benefits. Investments in equity and fixed income funds are included in current marketable securities and were $74 million and $46 million, respectively, at December 31, 2013 and $57 million and $47 million, respectively, at December 31, 2012. Investment income resulting from the change in fair value for the investments in equity and fixed income funds was $14 million in 2013 and $5 million in 2012.

Qualifying Hedges

The following summarizes the fair value of outstanding derivatives:



		December 31, 2013					December 31, 2012
Dollars in Millions	Balance Sheet Location	Notional		Fair Value			Notional		Fair Value
Derivatives designated as hedging instruments:
Interest rate swap contracts	Other assets	$	673	$	64		$	573	$	146
Interest rate swap contracts	Other liabilities	1,950		(27		)	—		—
Foreign currency forward contracts	Prepaid expenses and other	301		44			—		—
Foreign currency forward contracts	Other assets	100		6			735		59
Foreign currency forward contracts	Accrued expenses	704		(31		)	916		(30		)
Foreign currency forward contracts	Other liabilities	263		(4		)	—		—

Cash Flow Hedges — Foreign currency forward contracts are primarily utilized to hedge forecasted intercompany inventory purchase transactions in certain foreign currencies. These forward contracts are designated as cash flow hedges with the effective portion of changes in fair value being temporarily reported in accumulated OCI and recognized in earnings when the hedged item affects earnings. The net gains on foreign currency forward contracts are expected to be reclassified to cost of products sold within the next two years, including $14 million of pre-tax gains to be reclassified within the next 12 months. The notional amount of outstanding foreign currency forward contracts was primarily attributed to the Euro ($780 million) and Japanese yen ($247 million) at December 31, 2013.

Cash flow hedge accounting is discontinued when the forecasted transaction is no longer probable of occurring on the originally forecasted date, or 60 days thereafter, or when the hedge is no longer effective. Assessments to determine whether derivatives designated as qualifying hedges are highly effective in offsetting changes in the cash flows of hedged items are performed at inception and on a quarterly basis. Any ineffective portion of the change in fair value is included in current period earnings. The earnings impact related to discontinued cash flow hedges and hedge ineffectiveness was not significant during all periods presented.

Net Investment Hedges — Non-U.S. dollar borrowings of €541 million ($741 million) are designated to hedge the foreign currency exposures of the net investment in certain foreign affiliates. These borrowings are designated as net investment hedges and recognized in long term debt. The effective portion of foreign exchange gains or losses on the remeasurement of the debt is recognized in the foreign currency translation component of accumulated OCI with the related offset in long term debt.

Fair Value Hedges — Fixed-to-floating interest rate swap contracts are designated as fair value hedges and are used as part of an interest rate risk management strategy to create an appropriate balance of fixed and floating rate debt. The swaps and underlying debt for the benchmark risk being hedged are recorded at fair value. The effective interest rate paid on fixed-to-floating interest rate swaps is one-month LIBOR (0.17% as of December 31, 2013) plus an interest rate spread ranging from (0.8)% to 4.4%. When the underlying swap is terminated prior to maturity, the fair value basis adjustment to the underlying debt instrument is amortized into earnings as a reduction to interest expense over the remaining life of the debt.

Fixed-to-floating interest rate swap contracts were executed in 2013 to convert $2,050 million notional amount from fixed rate to variable rate debt.

During 2011, fixed-to-floating interest rate swap contracts of $1.6 billion notional amount and €1.0 billion notional amount were terminated generating total proceeds of $356 million (including accrued interest of $66 million).

Debt Obligations

Short-term borrowings and the current portion of long-term debt includes:



	December 31,
Dollars in Millions	2013		2012
Bank drafts and short-term borrowings	$	359	$	162
Current portion of long-term debt	—		664
Total	$	359	$	826

Long-term debt and the current portion of long-term debt includes:



	December 31,
Dollars in Millions	2013			2012
Principal Value:
5.25% Notes due 2013	$	—		$	597
4.375% Euro Notes due 2016	684			659
0.875% Notes due 2017	750			750
5.45% Notes due 2018	582			582
1.75% Notes due 2019	500			—
4.625% Euro Notes due 2021	684			659
2.000% Notes due 2022	750			750
7.15% Debentures due 2023	304			304
3.250% Notes due 2023	500			—
6.80% Debentures due 2026	330			330
5.875% Notes due 2036	625			625
6.125% Notes due 2038	480			480
3.250% Notes due 2042	500			500
4.500% Notes due 2044	500			—
6.88% Debentures due 2097	260			260
0% - 5.75% Other - maturing 2014 - 2030	144			135
Subtotal	7,593			6,631

Adjustments to Principal Value:
Fair value of interest rate swap contracts	37			146
Unamortized basis adjustment from swap terminations	442			509
Unamortized bond discounts	(64		)	(54		)
Total	$	8,008		$	7,232

Current portion of long-term debt^(a)	$	27		$	664
Long-term debt	7,981			6,568


(a)	Included in liabilities related to assets held-for-sale at December 31, 2013.

Included in other debt is $49 million of Floating Rate Convertible Senior Debentures due 2023 which can be redeemed by the holders at par on September 15, 2018 or if a fundamental change in ownership occurs. The Debentures are callable at par at any time by the Company. The Debentures have a current conversion price of $39.58, equal to a conversion rate of 25.2623 shares for each $1,000 principal amount, subject to certain anti-dilutive adjustments.

The average amount of commercial paper outstanding was $259 million at a weighted-average interest rate of 0.12% during 2013. The maximum month end amount of commercial paper outstanding was $820 million with no outstanding borrowings at December 31, 2013.

During the fourth quarter of 2013, $1.5 billion of senior unsecured notes were issued: $500 million in aggregate principal amount of 1.750% Notes due 2019, $500 million in aggregate principal amount of 3.250% Notes due 2023 and $500 million in aggregate principal amount of 4.500% Notes due 2044 in a registered public offering . Interest on the notes will be paid semi-annually. The notes rank equally in right of payment with all of BMS’s existing and future senior unsecured indebtedness. BMS may redeem the notes, in whole or in part, at any time at a predetermined redemption price. The net proceeds of the note issuances were $1,477 million, which is net of a discount of $12 million and deferred loan issuance costs of $11 million.

During the third quarter of 2012, $2.0 billion of senior unsecured notes were issued: $750 million in aggregate principal amount of 0.875% Notes due 2017, $750 million in aggregate principal amount of 2.000% Notes due 2022 and $500 million in aggregate principal amount of 3.250% Notes due 2042 in a registered public offering. Interest on the notes will be paid semi-annually. The notes rank equally in right of payment with all of BMS’s existing and future senior unsecured indebtedness. BMS may redeem the notes, in whole or in part, at any time at a predetermined redemption price. The net proceeds of the note issuances were $1,950 million, which is net of a discount of $36 million and deferred loan issuance costs of $14 million.

The $597 million principal amount of 5.25% Notes Due 2013 matured and was repaid in the third quarter of 2013. Substantially all of the $2.0 billion debt obligations assumed in the acquisition of Amylin were repaid during the third quarter of 2012, including a promissory note with Lilly with respect to a revenue sharing obligation and Amylin senior notes due 2014. In January 2014, notices were provided to the holders of the 5.45% Notes due 2018 that BMS will exercise its call option to redeem the notes in their entirety in February 2014. The outstanding principal amount of the notes is $582 million.

The principal value of long-term debt obligations was $7,593 million at December 31, 2013, of which $27 million is due in 2014, $684 million is due in 2016, $750 million is due in 2017, $631 million is due in 2018 and the remaining $5,501 million is due in 2019 or thereafter. The fair value of long-term debt was $8,487 million and $8,285 million at December 31, 2013 and 2012, respectively, and was estimated based upon the quoted market prices for the same or similar debt instruments. The fair value of short-term borrowings approximates the carrying value due to the short maturities of the debt instruments.

There were no debt repurchases in 2013. Debt repurchase activity for 2012 and 2011, including repayment of the Amylin debt obligations, was as follows:



Dollars in Millions	2012		2011
Principal amount	$	2,052	$	71
Carrying value	2,081		88
Repurchase price	2,108		78
Notional amount of interest rate swap contracts terminated	6		34
Swap termination proceeds	2		6
Total loss/(gain)	27		(10		)

Interest payments were $268 million in 2013, $241 million in 2012 and $171 million in 2011 net of amounts related to interest rate swap contracts.

BMS has two separate $1.5 billion five-year revolving credit facilities from a syndicate of lenders. The facilities provide for customary terms and conditions with no financial covenants and are extendable on any anniversary date with the consent of the lenders. No borrowings were outstanding under either revolving credit facility at December 31, 2013 or 2012.

At December 31, 2013, $633 million of financial guarantees were provided in the form of stand-by letters of credit and performance bonds. The stand-by letters of credit are issued through financial institutions in support of guarantees made by BMS and its affiliates for various obligations. The performance bonds were issued to support a range of ongoing operating activities, including sale of products to hospitals and foreign ministries of health, bonds for customs, duties and value added tax and guarantees related to miscellaneous legal actions. A significant majority of the outstanding financial guarantees will expire within the year and are not expected to be funded.