Fair value measurement

9 Months Ended

Sep. 30, 2019

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 values of each major class of the Company’s financial assets and liabilities measured at fair value on a recurring basis were 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 September 30, 2019, using:							Total
Assets:
Interest-bearing securities:
U.S. Treasury notes	$	1,167	$	—	$	—	$	1,167
U.S. Treasury bills	2,494		—		—		2,494
Other government-related debt securities:
U.S.	—		—		—		—
Foreign and other	—		925		—		925
Corporate debt securities:
Financial	—		2,140		—		2,140
Industrial	—		2,025		—		2,025
Other	—		537		—		537
Residential-mortgage-backed securities	—		516		—		516
Other mortgage- and asset-backed securities	—		43		—		43
Money market mutual funds	8,017		—		—		8,017
Other short-term interest-bearing securities	—		2,363		—		2,363
Equity securities	277		—		—		277
Derivatives:
Foreign currency contracts	—		339		—		339
Cross-currency swap contracts	—		12		—		12
Interest rate swap contracts	—		354		—		354
Total assets	$	11,955	$	9,254	$	—	$	21,209

Liabilities:
Derivatives:
Foreign currency contracts	$	—	$	6	$	—	$	6
Cross-currency swap contracts	—		478		—		478
Contingent consideration obligations	—		—		62		62
Total liabilities	$	—	$	484	$	62	$	546



	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, 2018, using:							Total
Assets:
Interest-bearing securities:
U.S. Treasury notes	$	2,663	$	—	$	—	$	2,663
U.S. Treasury bills	8,191		—		—		8,191
Other government-related debt securities:
U.S.	—		110		—		110
Foreign and other	—		932		—		932
Corporate debt securities:
Financial	—		2,697		—		2,697
Industrial	—		2,504		—		2,504
Other	—		562		—		562
Residential-mortgage-backed securities	—		1,422		—		1,422
Other mortgage- and asset-backed securities	—		469		—		469
Money market mutual funds	5,659		—		—		5,659
Other short-term interest-bearing securities	—		3,515		—		3,515
Equity securities	176		—		—		176
Derivatives:
Foreign currency contracts	—		182		—		182
Cross-currency swap contracts	—		170		—		170
Interest rate swap contracts	—		56		—		56
Total assets	$	16,689	$	12,619	$	—	$	29,308

Liabilities:
Derivatives:
Foreign currency contracts	$	—	$	26	$	—	$	26
Cross-currency swap contracts	—		401		—		401
Interest rate swap contracts	—		149		—		149
Contingent consideration obligations	—		—		72		72
Total liabilities	$	—	$	576	$	72	$	648

Interest-bearing and equity securities

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 and have 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 BBB+ or equivalent by Standard & Poor’s Financial Services LLC (S&P), Moody’s Investors Service, Inc. (Moody’s), or Fitch Ratings, Inc. (Fitch); and our corporate debt securities portfolio has weighted-average credit ratings of A– or equivalent 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 use 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. The 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 use 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. The inputs include reported trades of and broker-dealer quotes on the same or similar securities; issuer credit spreads; benchmark securities; prepayment or 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.

Derivatives

All of our foreign currency forward and option derivative 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, Moody’s or Fitch. We estimate the fair values of these contracts by taking into consideration valuations obtained from a third-party valuation service that uses 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, the London Interbank Offered Rate (LIBOR), swap rates and obligor credit default swap rates. In addition, inputs for our foreign currency option contracts include implied volatility measures. These inputs, when applicable, are at commonly quoted intervals. See Note 13, Derivative instruments.

Our cross-currency swap contracts are with counterparties that have minimum credit ratings of A– or equivalent by S&P, Moody’s or Fitch. We estimate the fair values of these contracts by taking into consideration valuations obtained from a third-party valuation service that uses 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 13, Derivative instruments.

Our interest rate swap contracts are with counterparties that have minimum credit ratings of A– or equivalent by S&P, Moody’s or Fitch. We estimate the fair values of these contracts by using an income-based industry-standard valuation model for which all significant inputs are observable either directly or indirectly. These inputs include LIBOR, swap rates and obligor credit default swap rates. See Note 13, Derivative instruments.

Contingent consideration obligations

As a result of our business combinations, we have incurred contingent consideration obligations. The contingent consideration obligations are recorded at their fair values by using probability-adjusted discounted cash flows, and we revalue these obligations each reporting period until the related contingencies have been resolved. The fair value measurements of these obligations are based on significant unobservable inputs related to licensing rights and product candidates acquired in business combinations, and they are reviewed quarterly by management in our R&D and commercial sales organizations. 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 for the three and nine months ended September 30, 2019 and 2018, were not material.

During the three and nine months ended September 30, 2019 and 2018, 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, except with respect to the 2018 discontinuance of the internal development of a nonkey program resulting in an impairment of an IPR&D asset of $330 million, which was recognized in Other operating expenses in the Condensed Consolidated Statements of Income and included in Other items, net, in the Condensed Consolidated Statements of Cash Flows.

Summary of the fair values of other financial instruments

Cash equivalents

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

Borrowings

We estimated the fair values of our borrowings by using Level 2 inputs. As of September 30, 2019 and December 31, 2018, the aggregate fair values of our borrowings were $33.3 billion and $35.0 billion, respectively, and the carrying values were $29.8 billion and $33.9 billion, respectively.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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