Hedging Activities and Fair Value Measurements

9 Months Ended

Sep. 30, 2021

Fair Value Disclosures [Abstract]

HEDGING ACTIVITIES AND FAIR VALUE MEASUREMENTS

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 and nonderivative 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.

Currency Hedging Instruments

Risk Management Strategy

Our risk from changes in currency exchange rates consists primarily of monetary assets and liabilities, forecasted 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 and nonderivative 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 Euro, Japanese yen, Chinese renminbi and Australian dollar. 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.

Hedge Designations and Relationships

Certain of our currency derivative instruments are designated as cash flow hedges under FASB ASC Topic 815, Derivatives and Hedging (FASB ASC Topic 815), 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 the Net change in derivative financial instruments component of Other comprehensive income (loss), net of tax (OCI) within our accompanying unaudited consolidated statements of comprehensive income (loss) until the underlying third-party transaction occurs. When the underlying third-party transaction occurs, we recognize the gain or loss in earnings within Cost of products sold in our accompanying unaudited consolidated statements of operations. In the event the hedging relationship is no longer effective, or if the occurrence of the hedged forecast transaction becomes no longer probable, we reclassify the gains or losses within Accumulated other comprehensive income (loss), net of tax (AOCI) to earnings at that time.

We also designate certain forward currency contracts as net investment hedges to hedge a portion of our net investments in certain of our entities with functional currencies denominated in the Swiss franc, Japanese yen, British pound sterling, South Korean won and Taiwan dollar. For these derivative instruments, we elected to use the spot method to assess hedge effectiveness. We also elected to exclude the spot-forward difference, referred to as the excluded component, from the assessment of hedge effectiveness and are amortizing this amount separately, as calculated at the date of designation, on a straight-line basis over the term of the currency forward contracts. As such, we defer recognition of foreign currency gains and losses within the Foreign currency translation adjustment (CTA) component of OCI, and we reclassify amortization of the excluded component from AOCI to current period earnings within Interest expense in our accompanying unaudited consolidated statements of operations.

We designate certain euro-denominated debt as net investment hedges to hedge a portion of our net investments in certain of our entities with functional currencies denominated in the Euro. As of September 30, 2021 and December 31, 2020, we designated as a net investment hedge a portion of our €900 million in aggregate principal amount of 0.625% senior notes issued in November 2019 and due in 2027. For these nonderivative instruments, we defer recognition of the foreign currency

remeasurement gains and losses within the CTA component of OCI. We reclassify these gains and losses to current period earnings within Other, net in our accompanying unaudited consolidated statements of operations only when the hedged item affects earnings, which would occur upon disposal or substantial liquidation of the underlying foreign subsidiary.

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 within Other, net in our accompanying unaudited consolidated statements of operations.

Interest Rate Hedging Instruments

Risk Management Strategy

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 mitigate the risk to our earnings and cash flows associated with 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 in accordance with FASB ASC Topic 815.

Hedge Designations and Relationships

We had no interest rate derivative instruments designated as cash flow hedges outstanding as of September 30, 2021 or December 31, 2020. Prior to 2020, we terminated interest rate derivative instruments that were designated as cash flow hedges and are continuing to recognize the amortization of the gains or losses originally recorded within AOCI to earnings as a component of Interest expense over the same period that the hedged item affects earnings, provided the hedge relationship remains effective. If we determine the hedge relationship is no longer effective, or if the occurrence of the hedged forecast transaction becomes no longer probable, we reclassify the amount of gains or losses from AOCI to earnings at that time.

In the event that we designate outstanding interest rate derivative instruments as cash flow hedges, we record the changes in the fair value of the derivatives within OCI until the underlying hedged transaction occurs. The balance of the deferred amounts on our terminated cash flow hedges within AOCI was a $25 million loss as of September 30, 2021 and a $29 million loss as of December 31, 2020. We recognized immaterial gains and losses in Interest expense relating to the amortization of our terminated cash flow hedges in the current and prior periods.

We had no interest rate derivative instruments designated as fair value hedges outstanding as of September 30, 2021 or December 31, 2020. Prior to 2018, we terminated interest rate derivative instruments that were designated as fair value hedges and are continuing to recognize the amortization of the gains or losses originally recorded within Long-term debt in our accompanying unaudited consolidated balance sheets into earnings as a component of Interest expense over the same period that the discount or premium associated with the hedged items affects earnings. In the event that we designate outstanding interest rate derivative instruments as fair value hedges, we record the changes in the fair values of interest rate derivatives designated as fair value hedges and of the underlying hedged debt instruments in Interest expense, which generally offset. The balance of the deferred gains on our terminated fair value hedges within Long-term debt was immaterial as of September 30, 2021 and December 31, 2020. We recognized immaterial gains in Interest expense relating to the amortization of the terminated fair value hedges in the current and prior periods.

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

(in millions)	FASB ASC Topic 815 Designation	As of
		September 30, 2021		December 31, 2020
Forward currency contracts	Cash flow hedge	$	4,344	$	4,531
Forward currency contracts	Net investment hedge	493		1,004
Foreign currency-denominated debt(1)	Net investment hedge	997		868
Forward currency contracts	Non-designated	4,838		4,946
Total Notional Outstanding		$	10,672	$	11,349

(1)    Foreign currency-denominated debt is the portion of the €900 million debt principal designated as a net investment hedge.

The remaining time to maturity as of September 30, 2021 is within 60 months for all forward currency contracts designated as cash flow hedges and generally less than one year for all non-designated forward currency contracts. The forward currency contracts designated as net investment hedges generally mature within the next year. The euro-denominated debt principal designated as a net investment hedge has a contractual maturity of December 1, 2027.

The following presents the effect of our derivative and nonderivative instruments designated as cash flow and net investment hedges under FASB ASC Topic 815 in our accompanying unaudited consolidated statements of operations. Refer to Note M – Changes in Other Comprehensive Income for the total amounts relating to derivative and nonderivative instruments presented within our accompanying unaudited consolidated statements of comprehensive income (loss).

	Effect of Hedging Relationships on Accumulated Other Comprehensive Income
	Amount Recognized in OCI on Hedges						Unaudited Consolidated Statements of Operations(1)			Amount Reclassified from AOCI into Earnings
(in millions)	Pre-Tax Gain (Loss)		Tax Benefit (Expense)		Gain (Loss) Net of Tax		Location of Amount Reclassified and Total Amount of Line Item			Pre-Tax (Gain) Loss		Tax (Benefit) Expense		(Gain) Loss Net of Tax
Three Months Ended September 30, 2021
Forward currency contracts
Cash flow hedges	$	79	$	(18)	$	61	Cost of products sold	$	900	$	(16)	$	3	$	(12)
Net investment hedges(2)	7		(2)		6		Interest expense	86		(2)		—		(2)
Foreign currency-denominated debt
Net investment hedges(3)	25		(6)		20		Other, net	(181)		—		—		—
Interest rate derivative contracts
Cash flow hedges	—		—		—		Interest expense	86		1		—		1

	Effect of Hedging Relationships on Accumulated Other Comprehensive Income
	Amount Recognized in OCI on Hedges						Unaudited Consolidated Statements of Operations(1)			Amount Reclassified from AOCI into Earnings
(in millions)	Pre-Tax Gain (Loss)		Tax Benefit (Expense)		Gain (Loss) Net of Tax		Location of Amount Reclassified and Total Amount of Line Item			Pre-Tax (Gain) Loss		Tax (Benefit) Expense		(Gain) Loss Net of Tax
Three Months Ended September 30, 2020
Forward currency contracts
Cash flow hedges	$	(64)	$	14	$	(50)	Cost of products sold	$	869	$	(20)	$	4	$	(15)
Net investment hedges(2)	(21)		5		(16)		Interest expense	86		(6)		1		(5)
Foreign currency-denominated debt
Net investment hedges(3)	(46)		10		(36)		Other, net	(64)		—		—		—
Interest rate derivative contracts
Cash flow hedges	—		—		—		Interest Expense	86		1		—		1

	Effect of Hedging Relationships on Accumulated Other Comprehensive Income
	Amount Recognized in OCI on Hedges						Unaudited Consolidated Statements of Operations(1)			Amount Reclassified from AOCI into Earnings
(in millions)	Pre-Tax Gain (Loss)		Tax Benefit (Expense)		Gain (Loss) Net of Tax		Location of Amount Reclassified and Total Amount of Line Item			Pre-Tax (Gain) Loss		Tax (Benefit) Expense		(Gain) Loss Net of Tax
Nine Months Ended September 30, 2021
Forward currency contracts
Cash flow hedges	$	234	$	(53)	$	182	Cost of products sold	$	2,739	$	(31)	$	7	$	(24)
Net investment hedges (2)	50		(11)		39		Interest expense	254		(11)		3		(9)
Foreign currency-denominated debt
Net investment hedges (3)	60		(14)		47		Other, net	(192)		—		—		—
Interest rate derivative contracts
Cash flow hedges	—		—		—		Interest expense	254		4		(1)		3

	Effect of Hedging Relationships on Accumulated Other Comprehensive Income
	Amount Recognized in OCI on Hedges						Unaudited Consolidated Statements of Operations(1)			Amount Reclassified from AOCI into Earnings
(in millions)	Pre-Tax Gain (Loss)		Tax Benefit (Expense)		Gain (Loss) Net of Tax		Location of Amount Reclassified and Total Amount of Line Item			Pre-Tax (Gain) Loss		Tax (Benefit) Expense		(Gain) Loss Net of Tax
Nine Months Ended September 30, 2020
Forward currency contracts
Cash flow hedges	$	47	$	(11)	$	36	Cost of products sold	$	2,465	$	(70)	$	16	$	(55)
Net investment hedges (2)	(4)		(21)		(25)		Interest expense	265		(18)		4		(14)
Foreign currency-denominated debt
Net investment hedges (3)	(44)		13		(31)		Other, net	(9)		—		—		—
Interest rate derivative contracts
Cash flow hedges	—		—		—		Interest expense	265		4		(1)		3

(1)    In all periods presented in the table above, the pre-tax (gain) loss amounts reclassified from AOCI to earnings represent the effect of the hedging relationships on earnings. All other amounts included in earnings related to hedging relationships were immaterial.

(2)    For our outstanding forward currency contracts designated as 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 of the excluded component has been excluded from the assessment of effectiveness in accordance with FASB ASC Topic 815. In the current and prior period, we did not recognize any gains or losses on the components included in the assessment of hedge effectiveness in earnings.

(3)    For our outstanding euro-denominated debt principal designated as a net investment hedge, the change in fair value attributable to changes in the spot rate is recorded in the CTA component of OCI. No amounts were reclassified from AOCI to current period earnings.

As of September 30, 2021, pre-tax net gains or losses for our derivative instruments designated, or previously designated, as cash flow and net investment hedges under FASB ASC Topic 815 that may be reclassified from AOCI to earnings within the next twelve months are presented below (in millions):

Designated Hedging Instrument	FASB ASC Topic 815 Designation	Location on Unaudited Consolidated Statements of Operations	Amount of Pre-Tax Gain (Loss) that may be Reclassified to Earnings
Forward currency contracts	Cash flow hedge	Cost of products sold	$	108
Forward currency contracts	Net investment hedge	Interest expense	5
Interest rate derivative contracts	Cash flow hedge	Interest expense	(5)

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 on Unaudited Consolidated Statements of Operations	Three Months Ended September 30,				Nine Months Ended September 30,
(in millions)		2021		2020		2021		2020
Net gain (loss) on currency hedge contracts	Other, net	$	(15)	$	29	$	(17)	$	20
Net gain (loss) on currency transaction exposures	Other, net	7		(30)		1		(33)
Net currency exchange gain (loss)		$	(8)	$	(1)	$	(17)	$	(13)

Fair Value Measurements

FASB ASC Topic 815 requires all derivative and nonderivative 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 and nonderivative instruments using the framework prescribed by FASB ASC Topic 820, Fair Value Measurements and Disclosures (FASB ASC Topic 820) and considering the estimated amount we would receive or pay to transfer these instruments at the reporting date with respect to 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 and nonderivative 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 and nonderivative assets and liabilities:

	Location on Unaudited Consolidated Balance Sheets(1)	As of
(in millions)		September 30, 2021		December 31, 2020
Derivative and Nonderivative Assets:
Designated Hedging Instruments
Forward currency contracts	Other current assets	$	152	$	53
Forward currency contracts	Other long-term assets	176		109
		328		162
Non-Designated Hedging Instruments
Forward currency contracts	Other current assets	41		79
Total Derivative and Nonderivative Assets		$	369	$	242
Derivative and Nonderivative Liabilities:
Designated Hedging Instruments
Forward currency contracts	Other current liabilities	$	24	$	44
Forward currency contracts	Other long-term liabilities	5		54
Foreign currency-denominated debt(2)	Other long-term liabilities	1,033		1,094
		1,063		1,191
Non-Designated Hedging Instruments
Forward currency contracts	Other current liabilities	57		71
Total Derivative and Nonderivative Liabilities		$	1,120	$	1,262

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

(2)    Foreign currency-denominated debt is the portion of the €900 million debt principal designated as a net investment hedge. A portion of this notional is subject to de-designation and re-designation based on changes in the underlying hedged item.

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
	September 30, 2021								December 31, 2020
(in millions)	Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3		Total
Assets
Money market funds and time deposits	$	1,537	$	—	$	—	$	1,537	$	1,584	$	—	$	—	$	1,584
Publicly-held equity securities	4		—		—		4		414		—		—		414
Hedging instruments	—		369		—		369		—		242		—		242
Licensing arrangements	—		—		280		280		—		—		365		365
	$	1,541	$	369	$	280	$	2,190	$	1,998	$	242	$	365	$	2,605
Liabilities
Hedging instruments	$	—	$	1,120	$	—	$	1,120	$	—	$	1,262	$	—	$	1,262
Contingent consideration liability	—		—		448		448		—		—		196		196
Licensing arrangements	—		—		297		297		—		—		407		407
	$	—	$	1,120	$	745	$	1,865	$	—	$	1,262	$	603	$	1,865

Our investments in money market funds and time deposits 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 consolidated balance sheets, in accordance with U.S. GAAP and our accounting policies. In addition to $1.537 billion invested in money market funds and time deposits as of September 30, 2021 and $1.584 billion as of December 31, 2020, we held $410 million in interest-bearing and non-interest-bearing bank accounts as of September 30, 2021 and $150 million as of December 31, 2020.

Our recurring fair value measurements using Level 3 inputs include those related to our contingent consideration liability. Refer to Note B – Acquisitions, Divestitures and Strategic Investments for a discussion of the changes in the fair value of our contingent consideration liability. In addition, our recurring fair value measurements using Level 3 inputs related to our licensing arrangements, including the contractual right to receive future royalty payments related to the Zytiga™ Drug. We recognized a financial asset and associated liability for our licensing arrangements at fair value in our accompanying unaudited consolidated balance sheets using the fair value option in accordance with FASB ASC Topic 825, Financial Instruments.

We own the contractual right to receive 50 percent of the future royalty payments from the licensee and remit such payments to the inventors associated with the intellectual property. Royalty payments we receive reduce the fair value of the financial asset and are presented within Proceeds from royalty rights, and payments we remit to inventors reduce the fair value of the financial liability and are presented within Payments for royalty rights within our unaudited consolidated statements of cash flows. We sold our right to receive and retain the other 50 percent of the future royalty payments in 2019 for an upfront cash payment, which we accounted for as a secured borrowing in accordance with FASB ASC Topic 860, Transfers and Servicing. Although we sold these rights, we continue to recognize at fair value the future royalty payments as a financial asset and associated liability. Royalty payments associated with the rights we sold no longer impact our cash flows, and we present this activity as Non-cash impact of transferred royalty rights in the supplemental information to our unaudited consolidated statements of cash flows. We reduce the fair value of the financial asset and associated liability when such non-cash activity occurs.

We have recorded the fair value of the financial asset and associated liability using a discounted cash flow approach considering the probability-weighted expected future cash flows to be generated by the royalty stream. The fair value of the financial liability also considers the related contractual provisions that govern our payment obligations. Significant increases or decreases in projected cash flows of the royalty stream and the related contractual provisions that govern our payment obligations, discount rates or the time until payment is made would have resulted in a significantly lower or higher fair value measurement of the licensing arrangements' financial asset and liability as of September 30, 2021. However, increases or decreases in the financial asset would be offset by increases or decreases in the financial liability, other than for timing of receipt and remittance; as such our earnings are not subject to material gains and losses from the licensing arrangement.

The recurring Level 3 fair value measurements of our licensing arrangements recognized in our accompanying unaudited consolidated balance sheets as of September 30, 2021 include the following significant unobservable inputs:

Licensing Arrangements	Fair Value as of September 30, 2021	Valuation Technique	Unobservable Input	Range				Weighted Average (1)
Financial Asset	$280 million	Discounted Cash Flow	Discount Rate	15%				15%
			Projected Year of Payment	2021		-	2025	2023
Financial Liability	$297 million	Discounted Cash Flow	Discount Rate	12	%	-	15%	13%
			Projected Year of Payment	2021		-	2026	2023

(1)    Unobservable inputs relate to a single financial asset and liability. As such, unobservable inputs were not weighted by the relative fair value of the instruments. For projected year of payment, the amount represents the median of the inputs and is not a weighted average.

Changes in the fair value of our licensing arrangements' financial asset were as follows:

(in millions)
Balance as of December 31, 2020	$	365
Proceeds from royalty rights	(62)
Non-cash impact of transferred royalty rights	(62)
Fair value adjustment (expense) benefit	40
Balance as of September 30, 2021	$	280

Changes in the fair value of our licensing arrangements' financial liability were as follows:

(in millions)
Balance as of December 31, 2020	$	407
Payments for royalty rights	(85)
Non-cash impact of transferred royalty rights	(62)
Fair value adjustment expense (benefit)	37
Balance as of September 30, 2021	$	297

Non-Recurring Fair Value Measurements

We hold certain assets and liabilities that are measured at fair value on a non-recurring basis in periods after 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, Divestitures and Strategic Investments for a discussion of our strategic investments and Note C – Goodwill and Other Intangible Assets for a discussion of the fair values of our intangible assets including goodwill.

The fair value of our outstanding debt obligations was $10.372 billion as of September 30, 2021, including $1.056 billion relating to our euro-denominated December 2027 Notes, and $10.774 billion as of December 31, 2020, including $1.118 billion relating to our euro-denominated December 2027 Notes. We determined fair value by using quoted market prices for our publicly registered senior notes, classified as Level 1 within the fair value hierarchy, and face value for commercial paper, term loans and credit facility borrowings outstanding. Refer to Note E – Contractual Obligations and Commitments for a discussion of our debt obligations.