Derivative Financial Instruments

9 Months Ended

Sep. 30, 2016

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Financial Instruments

DERIVATIVE FINANCIAL INSTRUMENTS

Foreign Currency Exposure

Our operations in foreign countries expose us to market risk associated with foreign currency exchange rate fluctuations between the U.S. dollar and various foreign currencies, the most significant of which are the Euro and Yen. In order to manage this risk, we may hedge a portion of our foreign currency exposures related to outstanding monetary assets and liabilities as well as forecasted product sales using foreign currency exchange forward or option contracts. In general, the market risk related to these contracts is offset by corresponding gains and losses on the hedged transactions. The credit risk associated with these contracts is driven by changes in interest and currency exchange rates and as a result, varies over time. By working only with major banks and closely monitoring current market conditions, we seek to limit the risk that counterparties to these contracts may be unable to perform. We also seek to limit our risk of loss by entering into contracts that permit net settlement at maturity. Therefore, our overall risk of loss in the event of a counterparty default is limited to the amount of any unrecognized gains on outstanding contracts (i.e., those contracts that have a positive fair value) at the date of default. We do not enter into derivative contracts for trading purposes.

We hedge our exposure to foreign currency exchange rate fluctuations for certain monetary assets and liabilities of our entities that are denominated in a non-functional currency. The derivative instruments we use to hedge this exposure are not designated as hedges, and as a result, changes in their fair value are recorded in Other income (expense), net, in our Condensed Consolidated Statements of Income.

We hedge our exposure to foreign currency exchange rate fluctuations for forecasted product sales that are denominated in a non-functional currency. The derivative instruments we use to hedge this exposure are designated as cash flow hedges and have maturity dates of 18 months or less. Upon executing a hedging contract and quarterly thereafter, we assess prospective hedge effectiveness using regression analysis which calculates the change in cash flow as a result of the hedge instrument. On a quarterly basis, we assess retrospective hedge effectiveness using a dollar offset approach. We exclude time value from our effectiveness testing and recognize changes in the time value of the hedge in Other income (expense), net. The effective component of our hedge is recorded as an unrealized gain or loss on the hedging instrument in Accumulated other comprehensive income (loss) (AOCI) within stockholders’ equity and the gains or losses are reclassified into product sales when the hedged transactions affect earnings. The majority of gains and losses related to the hedged forecasted transactions reported in AOCI at September 30, 2016 are expected to be reclassified to product sales within 12 months.

The cash flow effects of our derivative contracts for the nine months ended September 30, 2016 and 2015 are included within Net cash provided by operating activities in our Condensed Consolidated Statements of Cash Flows.

We had notional amounts on foreign currency exchange contracts outstanding of $8.8 billion at September 30, 2016 and $9.1 billion at December 31, 2015.

While all of our derivative contracts allow us the right to offset assets or liabilities, we have presented amounts on a gross basis. Under the International Swap Dealers Association, Inc. master agreements with the respective counterparties of the foreign currency exchange contracts, subject to applicable requirements, we are allowed to net settle transactions of the same currency with a single net amount payable by one party to the other. The following table summarizes the classification and fair values of derivative instruments in our Condensed Consolidated Balance Sheets (in millions):

	September 30, 2016
	Asset Derivatives			Liability Derivatives
	Classification	Fair Value		Classification	Fair Value
Derivatives designated as hedges:
Foreign currency exchange contracts	Other current assets	$	57	Other accrued liabilities	$	(156	)
Foreign currency exchange contracts	Other long-term assets	7		Other long-term obligations	(5		)
Total derivatives designated as hedges		64			(161		)
Derivatives not designated as hedges:
Foreign currency exchange contracts	Other current assets	1		Other accrued liabilities	(1		)
Total derivatives not designated as hedges		1			(1		)
Total derivatives		$	65		$	(162	)

	December 31, 2015
	Asset Derivatives			Liability Derivatives
	Classification	Fair Value		Classification	Fair Value
Derivatives designated as hedges:
Foreign currency exchange contracts	Other current assets	$	200	Other accrued liabilities	$	(32	)
Foreign currency exchange contracts	Other long-term assets	9		Other long-term obligations	(8		)
Total derivatives designated as hedges		209			(40		)
Derivatives not designated as hedges:
Foreign currency exchange contracts	Other current assets	1		Other accrued liabilities	(1		)
Total derivatives not designated as hedges		1			(1		)
Total derivatives		$	210		$	(41	)

The following table summarizes the effect of our foreign currency exchange contracts in our Condensed Consolidated Financial Statements (in millions):

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2016			2015		2016			2015
Derivatives designated as hedges:
Gains (losses) recognized in AOCI (effective portion)	$	(43	)	$	60	$	(258	)	$	336
Gains (losses) reclassified from AOCI into product sales (effective portion)	$	(9	)	$	137	$	67		$	469
Gains recognized in Other income (expense), net (ineffective portion and amounts excluded from effectiveness testing)	$	11		$	4	$	38		$	11
Derivatives not designated as hedges:
Gains (losses) recognized in Other income (expense), net	$	(62	)	$	21	$	(328	)	$	89

From time to time, we may discontinue cash flow hedges and as a result, record related amounts in Other income (expense), net in our Condensed Consolidated Statements of Income. There were no material amounts recorded in Other income (expense), net for the three and nine months ended September 30, 2016 and 2015 as a result of the discontinuance of cash flow hedges.

As of September 30, 2016 and December 31, 2015, we held one type of financial instrument, derivative contracts related to foreign currency exchange contracts. The following table summarizes the potential effect of offsetting derivatives by type of financial instrument in our Condensed Consolidated Balance Sheets (in millions):

									Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet
Description	Gross Amounts of Recognized Assets/Liabilities			Gross Amounts Offset in the Condensed Consolidated Balance Sheet		Amounts of Assets/Liabilities Presented in the Condensed Consolidated Balance Sheet			Derivative Financial Instruments			Cash Collateral Received/Pledged		Net Amount (Legal Offset)
As of September 30, 2016
Derivative assets	$	65		$	—	$	65		$	(65	)	$	—	$	—
Derivative liabilities	(162		)	—		(162		)	65			—		(97		)
As of December 31, 2015
Derivative assets	$	210		$	—	$	210		$	(38	)	$	—	$	172
Derivative liabilities	(41		)	—		(41		)	38			—		(3		)

May 2016 Convertible Senior Notes and Convertible Note Hedges

In March 2016, we exercised our option to elect cash for the settlement of the conversion value in excess of the principal amount (the conversion spread) of our remaining convertible senior notes due in May 2016 (the Convertible Notes) and for the related convertible note hedges. Until our cash settlement election, the conversion spread of the Convertible Notes and the convertible note hedges met the applicable criteria for equity classification and were therefore recorded in Stockholders’ equity in our Condensed Consolidated Balance Sheets. Upon our cash settlement election, we reclassified $733 million of the fair value of the conversion spread from Stockholders’ equity to Current portion of long-term debt and other obligations, net, and reclassified $733 million of the fair value of the convertible note hedges from Stockholders’ equity to Prepaid and other current assets in our Condensed Consolidated Balance Sheets. At March 31, 2016, we revalued both the conversion spread and the convertible note hedges at $792 million, respectively, and recorded a loss of $59 million on the conversion spread and a gain of $59 million on the convertible note hedges in our Condensed Consolidated Statements of Income.

During the second quarter of 2016, we settled both the conversion spread and the convertible note hedges associated with the Convertible Notes. Upon settlement, we revalued both the conversion spread and the convertible note hedges at $861 million, respectively, and recorded a loss of $69 million on the conversion spread and a gain of $69 million on the convertible note hedges in our Condensed Consolidated Statements of Income.