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Fair Value Measurements
 6 Months Ended
Jul. 01, 2012
Fair Value Disclosures [Abstract]  
FAIR VALUE MEASUREMENTS
FAIR VALUE MEASUREMENTS

The Company uses forward exchange contracts to manage its exposure to the variability of cash flows, primarily related to the foreign exchange rate changes of future intercompany product and third-party purchases of raw materials denominated in foreign currency. The Company also uses cross currency interest rate swaps to manage currency risk primarily related to borrowings. Both types of derivatives are designated as cash flow hedges. The Company also uses forward exchange contracts to manage its exposure to the variability of cash flows for repatriation of foreign dividends. These contracts are designated as net investment hedges. Additionally, the Company uses forward exchange contracts to offset its exposure to certain foreign currency assets and liabilities. These forward exchange contracts are not designated as hedges, and therefore, changes in the fair values of these derivatives are recognized in earnings, thereby offsetting the current earnings effect of the related foreign currency assets and liabilities. The Company does not enter into derivative financial instruments for trading or speculative purposes, or that contain credit risk related contingent features or requirements to post collateral. On an ongoing basis, the Company monitors counterparty credit ratings. The Company considers credit non-performance risk to be low, because the Company enters into agreements with commercial institutions that have at least an A (or equivalent) credit rating. As of July 1, 2012, the Company had notional amounts outstanding for forward foreign exchange contracts and cross currency interest rate swaps of $22.7 billion and $2.8 billion, respectively.

All derivative instruments are recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether the derivative is designated as part of a hedge transaction, and if so, the type of hedge transaction.

The designation as a cash flow hedge is made at the entrance date of the derivative contract. At inception, all derivatives are expected to be highly effective. Changes in the fair value of a derivative that is designated as a cash flow hedge and is highly effective are recorded in accumulated other comprehensive income until the underlying transaction affects earnings, and are then reclassified to earnings in the same account as the hedged transaction. Gains/losses on net investment hedges are accounted for through the currency translation account and are insignificant. On an ongoing basis, the Company assesses whether each derivative continues to be highly effective in offsetting changes in the cash flows of hedged items. If and when a derivative is no longer expected to be highly effective, hedge accounting is discontinued. Hedge ineffectiveness, if any, is included in current period earnings in Other (income) expense, net.

As of July 1, 2012, the balance of deferred net losses on derivatives included in accumulated other comprehensive income was $201 million after-tax. For additional information, see the Consolidated Statements of Comprehensive Income and Note 7. The Company expects that substantially all of the amounts related to foreign exchange contracts will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period. The maximum length of time over which the Company is hedging transaction exposure is 18 months excluding interest rate swaps. The amount ultimately realized in earnings will differ as foreign exchange rates change. Realized gains and losses are ultimately determined by actual exchange rates at maturity of the derivative.

The following table is a summary of the activity related to derivatives designated as hedges for the fiscal second quarters in 2012 and 2011:

 
 
 
 
 
 
 
 
 
 
 
Gain/ (Loss)
recognized in
Accumulated
OCI(1)
 
Gain/(Loss) reclassified from
Accumulated OCI
into income(1)
 
Gain/ (Loss)
recognized in
Other
income/expense(2)
 
 
Fiscal Second Quarters Ended
(Dollars in Millions)
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Cash Flow Hedges by Income Statement Caption
 
 
 
 
 
 
 
 
 
 
 
 
Sales to customers(A)
 
$
(42
)
 
—

 
(10
)
 
—

 
(1
)
 
—

Cost of products sold(A)
 
(97
)
 
12

 
(13
)
 
(44
)
 
1

 
6

Research and development expense(A)
 
30

 
28

 
11

 
18

 
—

 
(2
)
Interest (income)/Interest expense, net(B)
 
(41
)
 
(31
)
 
(6
)
 
(16
)
 
—

 
—

Other (income)expense, net(A)
 
39

 
(7
)
 
9

 
2

 
(1
)
 
—

Total
 
$
(111
)
 
2

 
(9
)
 
(40
)
 
(1
)
 
4


The following table is a summary of the activity related to derivatives designated as hedges for the first fiscal six months in 2012 and 2011:

 
 
 
 
 
 
 
 
 
 
 
Gain/ (Loss)
recognized in
Accumulated
OCI(1)
 
Gain/ (Loss) reclassified from
Accumulated OCI
into income(1)
 
Gain/ (Loss)
recognized in
other
income/expense(2)
 
 
Fiscal Six Months Ended
(Dollars in Millions)
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Cash Flow Hedges by Income Statement Caption
 
 
 
 
 
 
 
 
 
 
 
 
Sales to customers(A)
 
$
(14
)
 
27

 
(30
)
 
(10
)
 
—

 
(2
)
Cost of products sold(A)
 
(39
)
 
92

 
(34
)
 
(106
)
 
—

 
3

Research and development expense(A)
 
11

 
(8
)
 
13

 
19

 
—

 
(2
)
Interest (income)/Interest expense, net(B)
 
(42
)
 
(40
)
 
(9
)
 
(18
)
 
—

 
—

Other (income)expense, net(A)
 
(1
)
 
(59
)
 
8

 
(3
)
 
(1
)
 
2

Total
 
$
(85
)
 
12

 
(52
)
 
(118
)
 
(1
)
 
1

 
 
 
 
 
 
 
 
 
 
 
 
 

All amounts shown in the tables above are net of tax.
(1) Effective portion
(2) Ineffective portion
(A) Foreign exchange contracts
(B) Cross currency interest rate swaps

For the fiscal second quarters ended July 1, 2012 and July 3, 2011, a loss of $17 million and a loss of $7 million, respectively, were recognized in Other (income)expense, net, relating to foreign exchange contracts not designated as hedging instruments.

For the first fiscal six months ended July 1, 2012 and July 3, 2011, a loss of $26 million and a gain of $8 million, respectively, were recognized in Other (income)expense, net, relating to foreign exchange contracts not designated as hedging instruments.

Fair value is the exit price that would be received to sell an asset or paid to transfer a liability. Fair value is a market-based measurement that is determined using assumptions that market participants would use in pricing an asset or liability. The authoritative literature establishes a three-level hierarchy to prioritize the inputs used in measuring fair value. The levels within the hierarchy are described below with Level 1 having the highest priority and Level 3 having the lowest.

The fair value of a derivative financial instrument (i.e., foreign exchange contract or cross currency interest rate swap) is the aggregation by currency of all future cash flows discounted to its present value at the prevailing market interest rates and subsequently converted to the U.S. dollar at the current spot foreign exchange rate. The Company does not believe that fair values of these derivative instruments materially differ from the amounts that could be realized upon settlement or maturity, or that the changes in fair value will have a material effect on the Company’s results of operations, cash flows or financial position. The Company also holds equity investments which are classified as Level 1 because they are traded in an active exchange market. The Company did not have any other significant financial assets or liabilities which would require revised valuations under this standard that are recognized at fair value.


The following three levels of inputs are used to measure fair value:

Level 1 — Quoted prices in active markets for identical assets and liabilities.
Level 2 — Significant other observable inputs.
Level 3 — Significant unobservable inputs.

The Company’s significant financial assets and liabilities measured at fair value as of July 1, 2012 and January 1, 2012 were as follows:
 
 
July 1, 2012
 
 
 
January 1, 2012
(Dollars in Millions)
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Total(1)
Derivatives designated as hedging instruments:
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
—

 
449

 
—

 
449

 
442

Cross currency interest rate swaps(2)
 
—

 
17

 
—

 
17

 
15

Total
 
—

 
466

 
—

 
466

 
457

Liabilities:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
—

 
403

 
—

 
403

 
452

Cross currency interest rate swaps(3)
 
—

 
699

 
—

 
699

 
594

Total
 
—

 
1,102

 
—

 
1,102

 
1,046

Derivatives not designated as hedging instruments:
 
 
 
 
 
 
 
 
 
 
Assets:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
—

 
22

 
—

 
22

 
29

Swiss Franc Option*
 
—

 
—

 
—

 
—

 
17

Total
 
—

 
22

 
—

 
22

 
46

Liabilities:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
—

 
41

 
—

 
41

 
34

Other Investments(4)
 
$
1,675

 
—

 
—

 
1,675

 
1,563


*    Currency option related to the acquisition of Synthes, Inc., which expired in January 2012.
(1)
As of January 1, 2012, these assets and liabilities are classified as Level 2 with the exception of Other Investments of $1,563 million which are classified as Level 1.
(2)
Includes $14 million and $15 million of non-current assets for July 1, 2012 and January 1, 2012, respectively.
(3)
Includes $699 million and $594 million of non-current liabilities for July 1, 2012 and January 1, 2012, respectively.
(4)
Classified as non-current other assets.


Financial Instruments not measured at Fair Value:

The following financial assets and liabilities are held at carrying amount on the consolidated balance sheet as of July 1, 2012:
(Dollars in Millions)
 
Carrying Amount

 
Estimated Fair Value

Financial Assets
 
 
 
 
Current Investments
 
 
 
 
Cash
 
$
3,459

 
3,459

Government securities and obligations
 
10,857

 
10,857

Corporate debt securities
 
529

 
529

Money market funds
 
1,620

 
1,620

Time deposits
 
450

 
450

Total cash, cash equivalents and current marketable securities
 
$
16,915

 
16,915

 
 
 
 
 
Fair value of government securities and obligations and corporate debt securities was estimated using quoted broker prices and significant other observable inputs.
Financial Liabilities
 
 
 
 
 
 
 
 
 
Current Debt
 
$
6,040

 
6,040

Non-Current Debt
 
 
 
 
3 month LIBOR+0.09% FRN due 2014
 
750

 
750

1.20% Notes due 2014
 
999

 
1,014

2.15% Notes due 2016
 
898

 
950

5.55% Debentures due 2017
 
1,000

 
1,223

5.15% Debentures due 2018
 
898

 
1,091

4.75% Notes due 2019 (1B Euro 1.2434)
 
1,237

 
1,475

3% Zero Coupon Convertible Subordinated Debentures due in 2020
 
203

 
194

2.95% Debentures due 2020
 
541

 
576

3.55% Notes due 2021
 
446

 
503

6.73% Debentures due 2023
 
250

 
345

5.50% Notes due 2024 (500 GBP 1.5539)
 
772

 
993

6.95% Notes due 2029
 
294

 
436

4.95% Debentures due 2033
 
500

 
597

5.95% Notes due 2037
 
995

 
1,391

5.85% Debentures due 2038
 
700

 
958

4.50% Debentures due 2040
 
539

 
631

4.85% Notes due 2041
 
298

 
370

Other
 
205

 
202

Total Non-Current Debt
 
$
11,525

 
13,699



The weighted average effective rate on non-current debt is 4.33%.

Fair value of the non-current debt was estimated using market prices, which were corroborated by quoted broker prices and significant other observable inputs.