Note 6: Financial Instruments

Financial instruments that potentially subject us to credit risk consist principally of trade receivables and interest-bearing investments. Wholesale distributors of life-science products account for a substantial portion of our trade receivables; collateral is generally not required. The risk associated with this concentration is mitigated by our ongoing credit-review procedures and insurance. A large portion of our cash is held by a few major financial institutions. We monitor our exposures with these institutions and do not expect any of these institutions to fail to meet their obligations. Major financial institutions represent the largest component of our investments in corporate debt securities. In accordance with documented corporate risk-management policies, we monitor the amount of credit exposure to any one financial institution or corporate issuer. We are exposed to credit-related losses in the event of nonperformance by counterparties to risk-management instruments but do not expect any counterparties to fail to meet their obligations given their high credit ratings.

Our derivative activities are initiated within the guidelines of documented corporate risk-management policies and offset losses and gains on the assets, liabilities, and transactions being hedged. Management reviews the correlation and effectiveness of our derivatives on a quarterly basis.

For derivative instruments that are designated and qualify as fair value hedges, the derivative instrument is marked to market with gains and losses recognized currently in income to offset the respective losses and gains recognized on the underlying exposure. For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of gains and losses is reported as a component of accumulated other comprehensive loss and reclassified into earnings in the same period the hedged transaction affects earnings. For derivative and non-derivative instruments that are designated and qualify as net investment hedges, the effective portion of foreign currency translation gains or losses due to spot rate fluctuations are reported as a component of accumulated other comprehensive loss. Hedge ineffectiveness is immediately recognized in earnings. Derivative contracts that are not designated as hedging instruments are recorded at fair value with the gain or loss recognized in current earnings during the period of change.

We may enter into foreign currency forward or option contracts to reduce the effect of fluctuating currency exchange rates (principally the euro, the British pound, Japanese yen, and the Swiss franc). Foreign currency derivatives used for hedging are put in place using the same or like currencies and duration as the underlying exposures. Forward and option contracts are principally used to manage exposures arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. These contracts are recorded at fair value with the gain or loss recognized in other–net, (income) expense. We may enter into foreign currency forward and option contracts and currency swaps as fair value hedges of firm commitments. Forward contracts generally have maturities not exceeding 12 months. At September 30, 2016, we had outstanding foreign currency forward commitments to purchase 946.7 million U.S. dollars and sell 844.8 million euro, commitments to purchase 1.79 billion euro and sell 2.00 billion U.S. dollars, commitments to purchase 742.5 million U.S. dollars and sell 75.42 billion Japanese yen, commitments to purchase 192.7 million British pounds and sell 225.2 million euro, commitments to purchase 266.9 million U.S. dollars and sell 204.2 million British pounds, and commitments to purchase 192.8 million Swiss francs and sell 196.9 million U.S. dollars, which will all settle within 30 days.

Foreign currency exchange risk is also managed through the use of foreign currency debt and cross-currency interest rate swaps. Our foreign currency-denominated notes, which had carrying amounts of $3.55 billion and $2.27 billion as of September 30, 2016 and December 31, 2015, respectively, have been designated as, and are effective as, economic hedges of net investments in certain of our euro-denominated and Swiss franc-denominated operations. Our cross-currency interest rate swaps that convert a portion of our U.S. dollar-denominated floating rate debt to euro-denominated floating rate debt have also been designated as, and are effective as, economic hedges of net investments in certain of our euro-denominated foreign operations.

In the normal course of business, our operations are exposed to fluctuations in interest rates which can vary the costs of financing, investing, and operating. We address a portion of these risks through a controlled program of risk management that includes the use of derivative financial instruments. The objective of controlling these risks is to limit the impact of fluctuations in interest rates on earnings. Our primary interest-rate risk exposure results from changes in short-term U.S. dollar interest rates. In an effort to manage interest-rate exposures, we strive to achieve an acceptable balance between fixed- and floating-rate debt and investment positions and may enter into interest rate swaps or collars to help maintain that balance.

Interest rate swaps or collars that convert our fixed-rate debt to a floating rate are designated as fair value hedges of the underlying instruments. Interest rate swaps or collars that convert floating-rate debt to a fixed rate are designated as cash flow hedges. Interest expense on the debt is adjusted to include the payments made or received under the swap agreements. Cash proceeds from or payments to counterparties resulting from the termination of interest rate swaps are classified as operating activities in our consolidated condensed statement of cash flows. At September 30, 2016, substantially all of our total long-term debt is at a fixed rate. We have converted approximately 30 percent of our long-term fixed-rate notes to floating rates through the use of interest rate swaps.

We may enter into forward contracts and designate them as cash flow hedges to limit the potential volatility of earnings and cash flow associated with forecasted sales of available-for-sale securities.

In March 2015, we issued $600.0 million of 1.25 percent fixed-rate notes due March 1, 2018, $800.0 million of 2.75 percent fixed-rate notes due June 1, 2025, and $800.0 million of 3.70 percent fixed-rate notes due March 1, 2045, with interest to be paid semi-annually. The proceeds from the issuance of the notes were used primarily to repay outstanding commercial paper issued in connection with our January 2015 acquisition of Novartis AH.

In June 2015, we issued euro-denominated notes consisting of €600.0 million of 1.00 percent fixed-rate notes due June 2, 2022, €750.0 million of 1.63 percent fixed-rate notes due June 2, 2026, and €750.0 million of 2.13 percent fixed-rate notes due June 3, 2030, with interest to be paid annually. The net cash proceeds of the offering of $2.27 billion were used primarily to purchase and redeem certain higher interest rate U.S. dollar-denominated notes and to repay outstanding commercial paper. We paid $1.95 billion to purchase and redeem notes with an aggregate principal amount of $1.65 billion and a net carrying value of $1.78 billion in June 2015, resulting in a pretax debt extinguishment loss of $166.7 million, which was included in other–net, (income) expense in our consolidated condensed statement of operations during the nine months ended September 30, 2015.

In May 2016, we issued Swiss franc-denominated notes consisting of Fr.200.0 million of 0.00 percent fixed-rate notes due May 24, 2018, Fr.600.0 million of 0.15 percent fixed-rate notes due May 24, 2024, and Fr.400.0 million of 0.45 percent fixed-rate notes due May 24, 2028, with interest to be paid annually. We are using the net cash proceeds of the offering of $1.21 billion for general corporate purposes, which may include the repayment or redemption prior to maturity of certain of our U.S. dollar denominated fixed-rate notes due March 2017.

We may enter into forward-starting interest rate swaps, which we designate as cash flow hedges, as part of any anticipated future debt issuances in order to reduce the risk of cash flow volatility from future changes in interest rates. Upon completion of a debt issuance and termination of the swap, the change in fair value of these instruments is recorded as part of other comprehensive income (loss) and is amortized to interest expense over the life of the underlying debt.

Upon issuance of our underlying U.S. dollar-denominated fixed-rate notes in March 2015, we terminated forward-starting interest rate contracts in designated cash flow hedging instruments with an aggregate notional amount of $1.35 billion and paid $206.3 million in cash to the counterparties for settlement. The settlement amount represented the fair value of the forward-starting interest rate contracts at the time of termination and was recorded in other comprehensive loss.

In connection with the June 2015 note purchase and redemption discussed above, we terminated certain interest rate swaps designated as fair value hedges with an aggregate notional amount of $876.0 million. As a result of the termination, we received cash of $20.2 million, which represented the fair value of the interest rate swaps at the time of termination. The related fair value adjustment was recorded as an increase to the carrying value of the underlying notes and was included as a component of the debt extinguishment loss.

The Effect of Risk-Management Instruments on the Consolidated Condensed Statement of Operations

The following effects of risk-management instruments were recognized in other–net, (income) expense:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
Fair value hedges:
Effect from hedged fixed-rate debt	$	(18.8	)	$	66.1		$	92.4		$	25.8
Effect from interest rate contracts	18.8			(66.1		)	(92.4		)	(25.8		)
Cash flow hedges:
Effective portion of losses on interest rate contracts reclassified from accumulated other comprehensive loss	3.8			3.7			11.2			10.0
Net (gains) losses on foreign currency exchange contracts not designated as hedging instruments	1.4			(14.9		)	105.6			7.2

The Effect of Risk-Management Instruments on Other Comprehensive Income (Loss)

The effective portion of risk-management instruments that was recognized in other comprehensive income (loss) is as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2016			2015			2016			2015
Net investment hedges:
Foreign currency-denominated notes	$	(37.0	)	$	(16.8	)	$	(80.0	)	$	(50.6	)
Cross-currency interest rate swaps	(4.1		)	—			2.2			—
Foreign currency exchange contracts	—			—			31.9			—
Cash flow hedges:
Forward-starting interest rate swaps	—			—			(3.4		)	(56.7		)

During the next 12 months, we expect to reclassify from accumulated other comprehensive loss to earnings $15.2 million of pretax net losses on cash flow hedges of the variability in expected future interest payments on our floating rate debt.

During the nine months ended September 30, 2016 and 2015, net losses related to ineffectiveness, as well as net losses related to the portion of our risk-management hedging instruments, fair value hedges, and cash flow hedges that were excluded from the assessment of effectiveness, were not material.

Fair Value of Financial Instruments

The following tables summarize certain fair value information at September 30, 2016 and December 31, 2015 for assets and liabilities measured at fair value on a recurring basis, as well as the carrying amount and amortized cost of certain other investments:



					Fair Value Measurements Using
	Carrying Amount		Cost ⁽¹⁾		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Fair Value
September 30, 2016
Cash equivalents	$	1,615.9	$	1,615.9	$	1,614.8	$	1.1	$	—	$	1,615.9

Short-term investments:
U.S. government and agency securities	$	81.0	$	81.0	$	81.0	$	—	$	—	$	81.0
Corporate debt securities	648.8		648.3		—		648.8		—		648.8
Asset-backed securities	5.3		5.3		—		5.3		—		5.3
Other securities	2.7		2.7		—		2.7		—		2.7
Short-term investments	$	737.8

Noncurrent investments:
U.S. government and agency securities	$	344.0	$	342.0	$	344.0	$	—	$	—	$	344.0
Corporate debt securities	3,104.7		3,084.7		—		3,104.7		—		3,104.7
Mortgage-backed securities	195.8		193.7		—		195.8		—		195.8
Asset-backed securities	474.8		473.3		—		474.8		—		474.8
Other securities	170.1		82.6		—		3.4		166.7		170.1
Marketable equity securities	178.5		80.5		178.5		—		—		178.5
Cost and equity method investments ⁽²⁾	559.1
Noncurrent investments	$	5,027.0

December 31, 2015
Cash equivalents	$	1,644.4	$	1,644.4	$	1,637.0	$	7.4	$	—	$	1,644.4

Short-term investments:
U.S. government and agency securities	$	153.2	$	153.4	$	153.2	$	—	$	—	$	153.2
Corporate debt securities	625.8		626.9		—		625.8		—		625.8
Asset-backed securities	3.3		3.3		—		3.3		—		3.3
Other securities	3.1		3.1		—		3.1		—		3.1
Short-term investments	$	785.4

Noncurrent investments:
U.S. government and agency securities	$	284.5	$	286.0	$	283.5	$	1.0	$	—	$	284.5
Corporate debt securities	1,962.6		1,995.8		—		1,962.6		—		1,962.6
Mortgage-backed securities	153.3		154.7		—		153.3		—		153.3
Asset-backed securities	441.9		443.1		—		441.9		—		441.9
Other securities	137.1		97.3		—		4.1		133.0		137.1
Marketable equity securities	128.9		74.8		128.9		—		—		128.9
Cost and equity method investments ⁽²⁾	538.3
Noncurrent investments	$	3,646.6

⁽¹⁾ For available-for-sale debt securities, amounts disclosed represent the securities' amortized cost.

⁽²⁾ Fair value disclosures are not applicable for cost method and equity method investments.



				Fair Value Measurements Using
	Carrying Amount			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Fair Value
Long-term debt, including current portion
September 30, 2016	$	(9,348.8	)	$	—	$	(10,064.6	)	$	—	$	(10,064.6	)
December 31, 2015	(7,978.5		)	—		(8,172.0		)	—		(8,172.0		)



				Fair Value Measurements Using
	Carrying Amount			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Fair Value
September 30, 2016
Risk-management instruments:
Interest rate contracts designated as fair value hedges:
Other receivables	$	5.8		$	—	$	5.8		$	—		$	5.8
Sundry	156.2			—		156.2			—			156.2
Cross-currency interest rate contracts designated as net investment hedges:
Sundry	1.6			—		1.6			—			1.6
Foreign exchange contracts not designated as hedging instruments:
Other receivables	8.4			—		8.4			—			8.4
Other current liabilities	(5.5		)	—		(5.5		)	—			(5.5		)
Contingent consideration liabilities ⁽¹⁾:
Other current liabilities	(235.0		)	—		—			(235.0		)	(235.0		)
Other noncurrent liabilities	(296.2		)	—		—			(296.2		)	(296.2		)

December 31, 2015
Risk-management instruments:
Interest rate contracts designated as fair value hedges:
Sundry	$	70.1		$	—	$	70.1		$	—		$	70.1
Other noncurrent liabilities	(0.4		)	—		(0.4		)	—			(0.4		)
Foreign exchange contracts not designated as hedging instruments:
Other receivables	13.1			—		13.1			—			13.1
Other current liabilities	(17.3		)	—		(17.3		)	—			(17.3		)
Contingent consideration liabilities ⁽¹⁾:
Other current liabilities	(243.7		)	—		—			(243.7		)	(243.7		)
Other noncurrent liabilities	(427.2		)	—		—			(427.2		)	(427.2		)

⁽¹⁾ Contingent consideration liabilities primarily relate to the Erbitux arrangement with BMS discussed in Note 4.

Risk-management instruments above are disclosed on a gross basis. There are various rights of setoff associated with certain of the risk-management instruments above that are subject to an enforceable master netting arrangement or similar agreements. Although various rights of setoff and master netting arrangements or similar agreements may exist with the individual counterparties to the risk-management instruments above, individually, these financial rights are not material.

We determine our Level 1 and Level 2 fair value measurements based on a market approach using quoted market values, significant other observable inputs for identical or comparable assets or liabilities, or discounted cash flow analyses. Level 3 fair value measurements for other investment securities are determined using unobservable inputs, including the investments' cost adjusted for impairments and price changes from orderly transactions. The fair value of cost and equity method investments is not readily available.

Contingent consideration liabilities primarily include contingent consideration related to Erbitux for which the fair value was estimated using a discounted cash flow analysis and Level 3 inputs, including projections representative of a market participant view for net sales in North America through September 2018 and an estimated discount rate. The amount to be paid is calculated as a tiered percentage of net sales (see Note 4) and will, therefore, vary directly with increases and decreases in net sales of Erbitux in North America. There is no cap on the amount that may be paid pursuant to this arrangement. The decrease in the fair value of the contingent consideration liabilities during the nine months ended September 30, 2016 was due primarily to cash payments of $171.8 million related to Erbitux. The change in the fair value of the contingent consideration liabilities recognized in earnings during the three and nine months ended September 30, 2016 was not material.

The table below summarizes the contractual maturities of our investments in debt securities measured at fair value as of September 30, 2016:



	Maturities by Period
	Total		Less Than 1 Year		1-5 Years		6-10 Years		More Than 10 Years
Fair value of debt securities	$	4,860.5	$	737.8	$	3,716.5	$	171.8	$	234.4

A summary of the fair value of available-for-sale securities in an unrealized gain or loss position and the amount of unrealized gains and losses (pretax) in accumulated other comprehensive loss follows:



	September 30, 2016		December 31, 2015
Unrealized gross gains	$	138.8	$	68.0
Unrealized gross losses	7.6		52.5
Fair value of securities in an unrealized gain position	3,570.3		764.5
Fair value of securities in an unrealized loss position	1,266.2		2,933.4

We periodically assess our investment securities for other-than-temporary impairment losses. Other-than-temporary impairment losses recognized during the three and nine months ended September 30, 2016 totaled $11.4 million and $53.0 million, respectively. Impairment losses recognized during the three months ended September 30, 2016 related primarily to our marketable equity securities, while impairment losses recognized during the nine months ended September 30, 2016 related primarily to our cost and equity method investments. Other-than-temporary impairment losses recognized during the three and nine months ended September 30, 2015 totaled $31.5 million and $41.3 million, respectively.

For fixed-income securities, the amount of credit losses are determined by comparing the difference between the present value of future cash flows expected to be collected on these securities and the amortized cost. Factors considered in assessing credit losses include the position in the capital structure, vintage and amount of collateral, delinquency rates, current credit support, and geographic concentration.

For equity securities, factors considered in assessing other-than-temporary impairment losses include the length of time and the extent to which the fair value has been less than cost, the financial condition and near term prospects of the issuer, our intent and ability to retain the securities for a period of time sufficient to allow for recovery in fair value, and general market conditions and industry specific factors.

As of September 30, 2016, the securities in an unrealized loss position include primarily our marketable equity securities as well as fixed-rate debt securities of varying maturities. Marketable equity securities are sensitive to market price adjustments for general market conditions and industry or sector specific factors, and fixed-rate debt securities are sensitive to changes in the yield curve and other market conditions. Approximately 90 percent of the fixed-rate debt securities in a loss position are investment-grade debt securities. As of September 30, 2016, we do not intend to sell, and it is not more likely than not that we will be required to sell the securities in a loss position before the market values recover or the underlying cash flows have been received, and there is no indication of default on interest or principal payments for any of our debt securities.

Activity related to our investment portfolio, substantially all of which related to available-for-sale securities, was as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2016		2015		2016		2015
Proceeds from sales	$	926.3	$	621.9	$	2,503.4	$	3,491.8
Realized gross gains on sales	12.8		151.0		18.0		253.3
Realized gross losses on sales	1.3		1.5		11.7		3.9

Realized gains and losses on sales of investments are computed based upon specific identification of the initial cost adjusted for any other-than-temporary declines in fair value that were recorded in earnings.

Accounts Receivable Factoring Arrangements

We have entered into accounts receivable factoring agreements with financial institutions to sell certain of our non-U.S. accounts receivable. These transactions are accounted for as sales and result in a reduction in accounts receivable because the agreements transfer effective control over and risk related to the receivables to the buyers. Our factoring agreements do not allow for recourse in the event of uncollectibility, and we do not retain interest in the underlying accounts receivable once sold. We derecognized $685.9 million and $670.6 million of accounts receivable as of September 30, 2016 and December 31, 2015, respectively, under these factoring arrangements. The cost of factoring such accounts receivable on our consolidated condensed results of operations for the nine months ended September 30, 2016 and 2015 was not material.