Fair value measurement

To estimate the fair value of our financial assets and liabilities, we use valuation approaches within a hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing an asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing an asset or liability and are developed based on the best information available in the circumstances. The fair value hierarchy is divided into three levels based on the source of inputs as follows:



Level 1	—	Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access
Level 2	—	Valuations for which all significant inputs are observable, either directly or indirectly, other than level 1 inputs
Level 3	—	Valuations based on inputs that are unobservable and significant to the overall fair value measurement

The availability of observable inputs can vary among the various types of financial assets and liabilities. To the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. In certain cases, the inputs used for measuring fair value may fall into different levels of the fair value hierarchy. In such cases, for financial statement disclosure purposes, the level in the fair value hierarchy within which the fair value measurement is categorized is based on the lowest level of input used that is significant to the overall fair value measurement.

The fair value of each major class of the Company’s financial assets and liabilities measured at fair value on a recurring basis was as follows (in millions):



	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Fair value measurement
as of June 30, 2016, using:							Total
Assets:
Available-for-sale investments:
U.S. Treasury securities	$	8,020	$	—	$	—	$	8,020
Other government-related debt securities:
U.S.	—		347		—		347
Foreign and other	—		1,866		—		1,866
Corporate debt securities:
Financial	—		8,238		—		8,238
Industrial	—		8,473		—		8,473
Other	—		1,018		—		1,018
Residential mortgage-backed securities	—		1,738		—		1,738
Other mortgage- and asset-backed securities	—		2,180		—		2,180
Money market mutual funds	1,673		—		—		1,673
Other short-term interest-bearing securities	—		1,014		—		1,014
Equity securities	123		—		—		123
Derivatives:
Foreign currency contracts	—		68		—		68
Cross-currency swap contracts	—		17		—		17
Interest rate swap contracts	—		266		—		266
Total assets	$	9,816	$	25,225	$	—	$	35,041

Liabilities:
Derivatives:
Foreign currency contracts	$	—	$	27	$	—	$	27
Cross-currency swap contracts	—		456		—		456
Forward interest rate contracts	—		4		—		4
Contingent consideration obligations in connection with business combinations	—		—		171		171
Total liabilities	$	—	$	487	$	171	$	658



	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Fair value measurement
as of December 31, 2015, using:							Total
Assets:
Available-for-sale investments:
U.S. Treasury securities	$	4,274	$	—	$	—	$	4,274
Other government-related debt securities:
U.S.	—		534		—		534
Foreign and other	—		1,739		—		1,739
Corporate debt securities:
Financial	—		7,871		—		7,871
Industrial	—		7,836		—		7,836
Other	—		885		—		885
Residential mortgage-backed securities	—		1,470		—		1,470
Other mortgage- and asset-backed securities	—		2,469		—		2,469
Money market mutual funds	3,370		—		—		3,370
Other short-term interest-bearing securities	—		528		—		528
Equity securities	136		—		—		136
Derivatives:
Foreign currency contracts	—		142		—		142
Interest rate swap contracts	—		71		—		71
Total assets	$	7,780	$	23,545	$	—	$	31,325

Liabilities:
Derivatives:
Foreign currency contracts	$	—	$	8	$	—	$	8
Cross-currency swap contracts	—		250		—		250
Interest rate swap contracts	—		3		—		3
Contingent consideration obligations in connection with business combinations	—		—		188		188
Total liabilities	$	—	$	261	$	188	$	449

The fair values of our U.S. Treasury securities, money market mutual funds and equity securities are based on quoted market prices in active markets with no valuation adjustment.

Most of our other government-related and corporate debt securities are investment grade with maturity dates of five years or less from the balance sheet date. Our other government-related debt securities portfolio is composed of securities with weighted-average credit ratings of A or equivalent by Moody’s Investors Service, Inc. (Moody’s) and A- by Standard & Poor’s Financial Services LLC (S&P) or Fitch, Inc. (Fitch); and our corporate debt securities portfolio has a weighted-average credit rating of BBB + or equivalent by S&P or Moody’s and A- by Fitch. We estimate the fair values of these securities by taking into consideration valuations obtained from third-party pricing services. The pricing services utilize industry standard valuation models, including both income- and market-based approaches, for which all significant inputs are observable, either directly or indirectly, to estimate fair value. These inputs include reported trades of and broker/dealer quotes on the same or similar securities; issuer credit spreads; benchmark securities; and other observable inputs.

Our residential mortgage-, other mortgage- and asset-backed securities portfolio is composed entirely of senior tranches, with credit ratings of AAA by S&P, Moody’s or Fitch. We estimate the fair values of these securities by taking into consideration valuations obtained from third-party pricing services. The pricing services utilize industry standard valuation models, including both income- and market-based approaches for which all significant inputs are observable, either directly or indirectly, to estimate fair value. These inputs include reported trades of and broker/dealer quotes on the same or similar securities; issuer credit spreads; benchmark securities; prepayment/default projections based on historical data; and other observable inputs.

We value our other short-term interest-bearing securities at amortized cost, which approximates fair value given their near-term maturity dates.

All of our foreign currency forward and option derivatives contracts have maturities of three years or less, and all are with counterparties that have minimum credit ratings of A- or equivalent by S&P or Moody’s. We estimated the fair values of these contracts by taking into consideration valuations obtained from a third-party valuation service that utilizes an income-based industry standard valuation model for which all significant inputs are observable either directly or indirectly. These inputs include foreign currency rates, London Interbank Offered Rates (LIBOR), swap rates and obligor credit default swap rates. In addition, inputs for our foreign currency option contracts include implied volatility measures. These inputs, where applicable, are at commonly quoted intervals. See Note 12, Derivative instruments.

Our cross-currency swap contracts are with counterparties that have minimum credit ratings of A- or equivalent by S&P or Moody’s. We estimated the fair values of these contracts by taking into consideration valuations obtained from a third-party valuation service that utilizes an income-based industry standard valuation model for which all significant inputs are observable either directly or indirectly. These inputs include foreign currency exchange rates, LIBOR, swap rates, obligor credit default swap rates and cross-currency basis swap spreads. See Note 12, Derivative instruments.

Our interest rate swap contracts are with counterparties that have minimum credit ratings of A- or equivalent by S&P or Moody’s. We estimated the fair values of these contracts by using an income-based industry standard valuation model for which all significant inputs were observable either directly or indirectly. These inputs included LIBOR, swap rates and obligor credit default swap rates.

Contingent consideration obligations

As a result of our business acquisitions, we incurred contingent consideration obligations, as discussed below. These contingent consideration obligations are recorded at their estimated fair values, and we revalue these obligations each reporting period until the related contingencies are resolved. The fair value measurements of these obligations are based on significant unobservable inputs related to product candidates acquired in business combinations and are reviewed quarterly by management in our R&D and commercial sales organizations. These inputs include, as applicable, estimated probabilities and timing of achieving specified regulatory and commercial milestones and estimated annual sales. Significant changes that increase or decrease the probabilities of achieving the related regulatory and commercial events, shorten or lengthen the time required to achieve such events, or increase or decrease estimated annual sales would result in corresponding increases or decreases in the fair values of these obligations, as applicable. Changes in the fair values of contingent consideration obligations are recognized in Other operating expenses in the Condensed Consolidated Statements of Income.

Changes in the carrying amounts of contingent consideration obligations were as follows (in millions):



	Three months ended June 30,					Six months ended June 30,
	2016			2015		2016			2015
Beginning balance	$	194		$	215	$	188		$	215
Net changes in valuation	(23		)	—		(17		)	—
Ending balance	$	171		$	215	$	171		$	215

As a result of our acquisition of Dezima in October 2015, we are obligated to pay its former shareholders up to $1.25 billion of additional consideration contingent upon achieving certain development and sales-related milestones and low single-digit royalties on net product sales above a certain threshold. The estimated fair values of the contingent consideration obligations had an aggregate value of $110 million at acquisition. See Note 3, Business combinations.

As a result of our acquisition of BioVex Group, Inc. (BioVex), in March 2011, we are obligated to pay its former shareholders up to $325 million of additional consideration contingent if certain sales thresholds are achieved within specified periods of time.

We estimate the fair values of the obligations to former shareholders of Dezima and BioVex by using probability-adjusted discounted cash flows, and we review underlying key assumptions on a quarterly basis. There were no significant changes in the fair values of contingent consideration obligations during the three and six months ended June 30, 2016.

During the six months ended June 30, 2016 and 2015, there were no transfers of assets or liabilities between fair value measurement levels, and there were no material remeasurements to the fair values of assets and liabilities that are not measured at fair value on a recurring basis.

Summary of the fair values of other financial instruments

Cash equivalents

The estimated fair values of cash equivalents approximate their carrying values due to the short-term nature of such financial instruments.

Borrowings

We estimated the fair value of our long-term debt (Level 2) by taking into consideration indicative prices obtained from a third-party financial institution that utilizes industry standard valuation models, including both income- and market-based approaches, for which all significant inputs are observable either directly or indirectly. These inputs include reported trades of and broker/dealer quotes on the same or similar securities; credit spreads; benchmark yields; foreign currency exchange rates, as applicable; and other observable inputs. As of June 30, 2016, and December 31, 2015, the aggregate fair values of our long-term debt were $36.8 billion and $33.1 billion, respectively, and the carrying values were $33.2 billion and $31.4 billion, respectively.