NOTE D – HEDGING ACTIVITIES AND FAIR VALUE MEASUREMENTS

Derivative Instruments and Hedging Activities

We address market risk from changes in foreign currency exchange rates and interest rates through risk management programs which include the use of derivative financial instruments. We operate these programs pursuant to documented corporate risk management policies and do not enter into derivative transactions for speculative purposes. Our derivative instruments do not subject our earnings to material risk, as the gains or losses on these derivatives generally offset losses or gains recognized on the hedged item.

We manage concentration of counterparty credit risk by limiting acceptable counterparties to major financial institutions with investment grade credit ratings, limiting the amount of credit exposure to individual counterparties and by actively monitoring counterparty credit ratings and the amount of individual credit exposure. We also employ master netting arrangements that limit the risk of counterparty non-payment on a particular settlement date to the net gain that would have otherwise been received from the counterparty. Although not completely eliminated, we do not consider the risk of counterparty default to be significant as a result of these protections. Further, none of our derivative instruments are subject to collateral or other security arrangements, nor do they contain provisions that are dependent on our credit ratings from any credit rating agency.

Our risk from changes in currency exchange rates consists primarily of monetary assets and liabilities, forecast intercompany and third-party transactions and net investments in certain subsidiaries. We manage currency exchange rate risk at a consolidated level to reduce the cost of hedging by taking advantage of offsetting transactions. We employ derivative instruments, primarily forward currency contracts, to reduce the risk to our earnings and cash flows associated with changes in currency exchange rates.

The success of our currency risk management program depends, in part, on forecast transactions denominated primarily in British pound sterling, Euro and Japanese yen. We may experience unanticipated currency exchange gains or losses to the extent the actual activity is different than forecast. In addition, changes in currency exchange rates related to any unhedged transactions may impact our earnings and cash flows.

Certain of our currency derivative instruments are designated as cash flow hedges under FASB ASC Topic 815, Derivatives and Hedging and are intended to protect the U.S. dollar value of forecasted transactions. The gain or loss on a derivative instrument designated as a cash flow hedge is recorded in Other comprehensive income (loss), net of tax (OCI) and is included in the Accumulated other comprehensive income (loss), net of tax (AOCI) caption of our unaudited condensed consolidated balance sheets until the underlying third-party transaction occurs. When the related third-party transaction occurs, we recognize the gain or loss in earnings within the Cost of products sold caption of our unaudited condensed consolidated statements of operations. In the event the hedging relationship is no longer effective, or if the hedged forecast transaction becomes no longer probable of occurring, we reclassify the amount of gains or losses on the derivative instrument designated as a cash flow hedge to earnings at that time.

We also use forward currency contracts that are not part of designated hedging relationships under FASB ASC Topic 815 as a part of our strategy to manage our exposure to currency exchange rate risk related to monetary assets and liabilities and related forecast transactions. These non-designated currency forward contracts have an original time to maturity consistent with the hedged currency transaction exposures, generally less than one year, and are marked-to-market with changes in fair value recorded to earnings and reflected within the Other, net caption of our unaudited condensed consolidated statements of operations.

Our interest rate risk relates primarily to U.S. dollar borrowings partially offset by U.S. dollar cash investments. We use interest rate derivative instruments to manage our earnings and cash flow exposure to changes in interest rates. Under these agreements we and the counterparty, at specified intervals, exchange the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional principal amount. We designate these derivative instruments either as fair value or cash flow hedges under FASB ASC Topic 815.

The changes in the fair value of interest rate derivatives designated as fair value hedges and the changes in the fair value of the underlying hedged debt instrument generally offset and are recorded within the Interest expense caption of our unaudited condensed consolidated statements of operations. We record the changes in the fair value of interest rate derivatives designated as cash flow hedges within OCI, which is included within the AOCI caption of our unaudited condensed consolidated balance sheets until the underlying hedged transaction occurs, at which time we recognize the gain or loss within Interest expense. In the event the hedging relationship is no longer effective, or if the hedged forecast transaction becomes no longer probable of occurring, we reclassify the amount of gains or losses on the interest rate derivative designated as a cash flow hedge to earnings at that time.

We are amortizing the realized gains or losses from interest rate derivative instruments previously designated as fair value or cash flow hedges into earnings as a component of Interest expense over the remaining term of the hedged item in accordance with FASB ASC Topic 815, so long as the hedge relationship remains effective. Prior to the adoption of ASC Update No. 2017-12, Derivatives and Hedging (Topic 815), the ineffective portion, if any, of our interest rate derivatives designated as either fair value or cash flow hedges was recognized in earnings in the period in which the hedging relationship exhibited ineffectiveness.

Certain of our currency forward contracts are designated as net investment hedges under FASB ASC Topic 815 and are intended to hedge a portion of our net investments in certain of our European, Swiss and Japanese operating entities. We have elected to use the spot method to assess effectiveness for our derivatives that are designated as net investment hedges. Under the spot method, the change in fair value attributable to changes in the spot rate is recorded in the Foreign currency translation adjustment (CTA), which is included within the AOCI caption of our unaudited condensed consolidated balance sheets. Therefore, the spot-forward difference is excluded from the assessment of effectiveness and accounted for separately.

Consistent with FASB ASC Topic 815, we have elected to amortize the excluded spot-forward difference associated with the currency forward contracts as calculated at the date of designation. Amortization will be recognized on a straight-line basis over the term of the currency forward contracts from the AOCI caption of our unaudited condensed consolidated balance sheets to reported earnings as a reduction of Interest expense.

The following table presents the contractual amounts of our derivative instruments outstanding:



(in millions)	FASB ASC Topic 815 Designation	As of
(in millions)	FASB ASC Topic 815 Designation	June 30, 2018		December 31, 2017
Forward currency contracts	Cash flow hedge	$	4,205	$	3,252
Forward currency contracts	Net investment hedge	1,455		—
Forward currency contracts	Non-designated	2,635		2,671
Total Notional Outstanding		$	8,295	$	5,923

The remaining time to maturity as of June 30, 2018 is within 60 months for all designated forward currency contracts and generally less than one year for all non-designated forward currency contracts.

We had no interest rate derivative instruments outstanding as of June 30, 2018 and December 31, 2017.

The following presents the effect of our derivative instruments designated as cash flow hedges and net investment hedges under FASB ASC Topic 815 on our accompanying unaudited condensed consolidated statements of operations:



(in millions)	Unaudited Condensed Consolidated Statements of Operations				Effective Amount Recognized in OCI									Effective Amount Reclassified from AOCI into Earnings
(in millions)	Location	Total			Pre-Tax Gain (Loss)			Tax Benefit (Expense)			Gain (Loss) Net of Tax			Pre-Tax (Gain) Loss			Tax (Benefit) Expense			(Gain) Loss Net of Tax
Three Months Ended June 30, 2018
Forward currency contracts	Cost of products sold	$	739		$	194		$	(44	)	$	151		$	10		$	(2	)	$	7
Forward currency contracts	Interest expense	(57		)	21			(5		)	16			(7		)	2			(5		)
					$	215		$	(48	)	$	167		$	3		$	(1	)	$	2

Three Months Ended June 30, 2017
Forward currency contracts	Cost of products sold	$	632		$	(6	)	$	2		$	(4	)	$	(27	)	$	10		$	(17	)
					$	(6	)	$	2		$	(4	)	$	(27	)	$	10		$	(17	)

Six Months Ended June 30, 2018
Forward currency contracts	Cost of products sold	$	1,411		$	77		$	(17	)	$	59		$	25		$	(6	)	$	19
Forward currency contracts	Interest expense	(119		)	21			(5		)	16			(7		)	2			(5		)
					$	97		$	(22	)	$	76		$	18		$	(4	)	$	14

Six Months Ended June 30, 2017
Forward currency contracts	Cost of products sold	$	1,282		$	(64	)	$	23		$	(41	)	$	(55	)	$	21		$	(34	)
Interest rate derivative contracts	Interest expense	(115		)	—			—			—			(1		)	—			(1		)
					$	(64	)	$	23		$	(41	)	$	(56	)	$	21		$	(35	)

For our outstanding net investment hedges, the net gain or loss reclassified from AOCI to earnings as a reduction of Interest expense represents the straight-line amortization of the excluded component as calculated at the date of designation. This initial value has been excluded from the assessment of effectiveness in accordance with FASB ASC Topic 815.

As of June 30, 2018, pre-tax net gains or losses for our derivative instruments designated, or previously designated, as fair value and cash flow hedges under FASB ASC Topic 815 that may be reclassified to earnings within the next twelve months are presented below (in millions):



Designated Derivative Instrument	FASB ASC Topic 815 Designation	Location in Unaudited Condensed Consolidated Statements of Operations	Amount of Pre-Tax Gain (Loss) that may be Reclassified to Earnings
Interest rate derivative contracts	Fair value hedge	Interest expense	$	12
Interest rate derivative contracts	Cash flow hedge	Interest expense	1
Forward currency contracts	Cash flow hedge	Cost of products sold	11
Forward currency contracts	Net investment hedge	Interest expense	41

Net gains and losses on currency hedge contracts not designated as hedging instruments offset by net gains and losses from currency transaction exposures are presented below:



	Location in Unaudited Condensed Consolidated Statements of Operations	Three Months Ended June 30,						Six Months Ended June 30,
(in millions)		2018			2017			2018			2017
Net gain (loss) on currency hedge contracts	Other, net	$	32		$	5		$	8		$	(12	)
Net gain (loss) on currency transaction exposures	Other, net	(33		)	(13		)	(17		)	4
Net currency exchange gain (loss)		$	(1	)	$	(8	)	$	(9	)	$	(8	)

Fair Value Measurements

FASB ASC Topic 815 requires all derivative instruments to be recognized at their fair values as either assets or liabilities on the balance sheet. We determine the fair value of our derivative instruments using the framework prescribed by FASB ASC Topic 820, Fair Value Measurements and Disclosures and considering the estimated amount we would receive or pay to transfer these instruments at the reporting date when taking into account current currency exchange rates, interest rates, the creditworthiness of the counterparty for unrealized gain positions and our own creditworthiness for unrealized loss positions. In certain instances, we may utilize financial models to measure fair value of our derivative instruments. In doing so, we use inputs that include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, other observable inputs for the asset or liability and inputs derived principally from, or corroborated by, observable market data by correlation or other means. The following are the balances of our derivative assets and liabilities:



	Location in Unaudited Condensed Consolidated Balance Sheets (1)	As of
(in millions)		June 30, 2018		December 31, 2017
Derivative Assets:
Designated Derivative Instruments
Forward currency contracts	Other current assets	$	24	$	7
Forward currency contracts	Other long-term assets	94		57
Net investment hedges	Other long-term assets	21		—
		139		64
Non-Designated Derivative Instruments
Forward currency contracts	Other current assets	64		18
Total Derivative Assets		$	202	$	82

Derivative Liabilities:
Designated Derivative Instruments
Forward currency contracts	Other current liabilities	$	9	$	37
Forward currency contracts	Other long-term liabilities	10		33
		19		69
Non-Designated Derivative Instruments
Forward currency contracts	Other current liabilities	26		21
Total Derivative Liabilities		$	45	$	90


(1)	We classify derivative assets and liabilities as current when the settlement date of the derivative contract is one year or less.

Recurring Fair Value Measurements

On a recurring basis, we measure certain financial assets and financial liabilities at fair value based upon quoted market prices. Where quoted market prices or other observable inputs are not available, we apply valuation techniques to estimate fair value. FASB ASC Topic 820 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The category of a financial asset or a financial liability within the valuation hierarchy is based upon the lowest level of input that is significant to the measurement of fair value. The three levels of the hierarchy are defined as follows:


•	Level 1 – Inputs to the valuation methodology are quoted market prices for identical assets or liabilities.


•	Level 2 – Inputs to the valuation methodology are other observable inputs, including quoted market prices for similar assets or liabilities and market-corroborated inputs.


•	Level 3 – Inputs to the valuation methodology are unobservable inputs based on management’s best estimate of inputs market participants would use in pricing the asset or liability at the measurement date, including assumptions about risk.

Assets and liabilities measured at fair value on a recurring basis consist of the following:



	As of
	June 30, 2018								December 31, 2017
(in millions)	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets
Money market and government funds	$	49	$	—	$	—	$	49	$	21	$	—	$	—	$	21
Publicly-held securities	1		—		—		1		15		—		—		15
Forward currency contracts	—		202		—		202		—		82		—		82
	$	50	$	202	$	—	$	253	$	36	$	82	$	—	$	118
Liabilities
Forward currency contracts	$	—	$	45	$	—	$	45	$	—	$	90	$	—	$	90
Accrued contingent consideration	—		—		279		279		—		—		169		169
	$	—	$	45	$	279	$	324	$	—	$	90	$	169	$	259

Our investments in money market and government funds are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. These investments are classified as Cash and cash equivalents within our accompanying unaudited condensed consolidated balance sheets, in accordance with U.S. GAAP and our accounting policies. In addition to $49 million invested in money market and government funds as of June 30, 2018, we had $159 million in interest bearing and non-interest bearing bank accounts. In addition to $21 million invested in money market and government funds as of December 31, 2017, we had $167 million in interest bearing and non-interest bearing bank accounts.

Our recurring fair value measurements using Level 3 inputs relate solely to our contingent consideration liability. Refer to Note B – Acquisitions and Strategic Investments for a discussion of the changes in the fair value of our contingent consideration liability.

Non-Recurring Fair Value Measurements

We hold certain assets and liabilities that are measured at fair value on a non-recurring basis in periods subsequent to initial recognition. The fair value of a measurement alternative investment is not estimated if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investment. Refer to Note B – Acquisitions and Strategic Investments for a discussion of our strategic investments.

Refer to Note C – Goodwill and Other Intangible Assets for a discussion of the fair values.

The fair value of our outstanding debt obligations was $6.702 billion as of June 30, 2018 and $5.945 billion as of December 31, 2017. We determined fair value by using quoted market prices for our publicly registered senior notes, classified as Level 1 within the fair value hierarchy, amortized cost for commercial paper and face value for term loans and credit facility borrowings outstanding. Refer to Note E – Borrowings and Credit Arrangements for a discussion of our debt obligations.