10-Q 1 goog10-qq32013.htm FORM 10-Q GOOG 10-Q Q3 2013


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
___________________________________________________
FORM 10-Q
___________________________________________________
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission file number: 000-50726
___________________________________________________
Google Inc.
(Exact name of registrant as specified in its charter)
___________________________________________________
Delaware
77-0493581
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
1600 Amphitheatre Parkway
Mountain View, CA 94043
(Address of principal executive offices, including zip code)
(650) 253-0000
(Registrant’s telephone number, including area code) 
___________________________________________________
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
  
Large accelerated filer  ý
  
Accelerated filer  ¨
  
 
Non-accelerated filer (Do not check if a smaller reporting company)  ¨             Smaller reporting company  ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
At October 17, 2013, there were 276,721,703 shares of Google’s Class A common stock outstanding and 57,365,706 shares of Google’s Class B common stock outstanding.





Google Inc.
Form 10-Q
For the Quarterly Period Ended September 30, 2013
TABLE OF CONTENTS

 
 
Page No.
Item 1
 
 
 
 
 
Item 2
Item 3
Item 4
Item 1
Item 1A
Item 2
Item 6
 
 
 


i


NOTE ABOUT FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding:

the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business;
seasonal fluctuations in internet usage and advertiser expenditures, traditional retail seasonality and macroeconomic conditions, which are likely to cause fluctuations in our quarterly results;
our plans to continue to invest in new businesses, products and technologies, systems, facilities, and infrastructure, to increase our hiring and provide competitive compensation programs, as well as to continue our current pace of acquisitions;
the potential for declines in our revenue growth rate;
our expectation that growth in advertising revenues from our websites will continue to exceed that from our Google Network Members’ websites, which will have a positive impact on our operating margins;
our expectation that we will continue to pay most of the fees we receive from advertisers to our Google Network Members;
our expectation that we will continue to take steps to improve the relevance of the ads we deliver and to reduce the number of accidental clicks;
fluctuations in aggregate paid clicks and average cost-per-click;
our belief that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates;
the expected increase of costs related to hedging activities under our foreign exchange risk management program;
our expectation that our cost of revenues, research and development expenses, sales and marketing expenses, and general and administrative expenses will increase in dollars and may increase as a percentage of revenues;
our potential exposure in connection with pending investigations, proceedings, and other contingencies;
our expectation about our board of directors’ intention to declare a dividend of shares of the new Class C capital stock, as well as the timing of that dividend, if declared and paid;
our expectation that our traffic acquisition costs will fluctuate in the future;
our continued investments in international markets;
estimates of our future compensation expenses;
fluctuations in our effective tax rate;
the sufficiency of our sources of funding;
our payment terms to certain advertisers, which may increase our working capital requirements; and
fluctuations in our capital expenditures;
as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report, including without limitation, the following sections: Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 1A, “Risk Factors.” Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, and in particular, the risks discussed under the caption “Risk Factors” in Part II, Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission (SEC). We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

1


As used herein, “Google,” “we,” “our,” and similar terms include Google Inc. and its subsidiaries, unless the context indicates otherwise.
“Google” and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies’ trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies.

2


PART I - FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS
Google Inc.
CONSOLIDATED BALANCE SHEETS
(In millions, except share and par value amounts which are reflected in thousands,
and par value per share amounts)
 
As of
December 31,
2012
 
As of
September 30,
2013
 
 
 
(unaudited)
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
14,778

 
$
15,242

Marketable securities
33,310

 
41,281

Total cash, cash equivalents, and marketable securities (including securities loaned of $3,160 and $5,103)
48,088

 
56,523

Accounts receivable, net of allowance of $581 and $486
7,885

 
7,921

Inventories
505

 
235

Receivable under reverse repurchase agreements
700

 
100

Deferred income taxes, net
1,144

 
1,154

Income taxes receivable, net
0

 
571

Prepaid revenue share, expenses and other assets
2,132

 
2,354

Total current assets
60,454

 
68,858

Prepaid revenue share, expenses and other assets, non-current
2,011

 
1,784

Non-marketable equity investments
1,469

 
1,843

Property and equipment, net
11,854

 
14,867

Intangible assets, net
7,473

 
6,290

Goodwill
10,537

 
11,426

Total assets
$
93,798

 
$
105,068

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
2,012

 
$
2,124

Short-term debt
2,549

 
3,009

Accrued compensation and benefits
2,239

 
1,999

Accrued expenses and other current liabilities
3,258

 
3,071

Accrued revenue share
1,471

 
1,472

Securities lending payable
1,673

 
1,893

Deferred revenue
895

 
907

Income taxes payable, net
240

 
0

Total current liabilities
14,337

 
14,475

Long-term debt
2,988

 
2,238

Deferred revenue, non-current
100

 
125

Income taxes payable, non-current
2,046

 
2,434

Deferred income taxes, net, non-current
1,872

 
2,097

Other long-term liabilities
740

 
710

Stockholders’ equity:
 
 
 
Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding
0

 
0

Class A and Class B common stock and additional paid-in capital, $0.001 par value per share: 12,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000); 329,979 (Class A 267,448, Class B 62,531) and par value of $330 (Class A $267, Class B $63) and 334,157 (Class A 276,681, Class B 57,476) and par value of $334 (Class A $277, Class B $57) shares issued and outstanding
22,835

 
25,004

Class C capital stock, $0.001 par value per share: 3,000,000 shares authorized; no shares issued and outstanding
0

 
0

Accumulated other comprehensive income
538

 
99

Retained earnings
48,342

 
57,886

Total stockholders’ equity
71,715

 
82,989

Total liabilities and stockholders’ equity
$
93,798

 
$
105,068

See accompanying notes.

3


Google Inc.
CONSOLIDATED STATEMENTS OF INCOME
(In millions, except share amounts which are reflected in thousands and per share amounts)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2013
 
2012
 
2013
 
(unaudited)
Revenues:
 
 
 
 
 
 
 
Google (advertising and other)
$
11,526

 
$
13,754

 
$
33,135

 
$
39,812

Motorola Mobile (hardware and other)
1,778

 
1,139

 
2,621

 
3,155

Total revenues
13,304

 
14,893

 
35,756

 
42,967

Costs and expenses:
 
 
 
 
 
 
 
Cost of revenues - Google (advertising and other) (1)
4,440

 
5,409

 
12,213

 
15,740

Cost of revenues - Motorola Mobile (hardware and other) (1)
1,515

 
1,004

 
2,208

 
2,680

Research and development (1)
1,879

 
2,017

 
4,858

 
5,841

Sales and marketing (1)
1,710

 
1,806

 
4,392

 
5,127

General and administrative (1)
1,020

 
1,213

 
2,719

 
3,535

Total costs and expenses
10,564

 
11,449

 
26,390

 
32,923

Income from operations
2,740

 
3,444

 
9,366

 
10,044

Interest and other income, net
65

 
24

 
474

 
405

Income from continuing operations before income taxes
2,805

 
3,468

 
9,840

 
10,449

Provision for income taxes
647

 
513

 
1,959

 
1,616

Net income from continuing operations
2,158

 
2,955

 
7,881

 
8,833

Net income (loss) from discontinued operations
18

 
15

 
(30
)
 
711

Net income
$
2,176

 
$
2,970

 
$
7,851

 
$
9,544

Net income (loss) per share of Class A and Class B common stock - basic:
 
 
 
 
 
 
 
Continuing operations
$
6.59

 
$
8.86

 
$
24.14

 
$
26.59

Discontinued operations
0.05

 
0.04

 
(0.09
)
 
2.14

Net income (loss) per share of Class A and Class B common stock - basic
$
6.64

 
$
8.90

 
$
24.05

 
$
28.73

Net income (loss) per share of Class A and Class B common stock - diluted:
 
 
 
 
 
 
 
Continuing operations
$
6.48

 
$
8.71

 
$
23.78

 
$
26.13

Discontinued operations
0.05

 
0.04

 
(0.09
)
 
2.10

Net income (loss) per share of Class A and Class B common stock - diluted
$
6.53

 
$
8.75

 
$
23.69

 
$
28.23

 
 
 
 
 
 
 
 
Shares used in per share calculation - basic
327,785

 
333,616

 
326,452

 
332,183

Shares used in per share calculation - diluted
333,314

 
339,235

 
331,414

 
338,078

______________________
 
 
 
 
 
 
 
(1) Includes stock-based compensation expense as follows:
 
 
 
 
 
 
 
Cost of revenues - Google (advertising and other)
$
103

 
$
133

 
$
259

 
$
342

Cost of revenues - Motorola Mobile (hardware and other)
6

 
4

 
10

 
14

Research and development
373

 
453

 
961

 
1,235

Sales and marketing
152

 
160

 
367

 
419

General and administrative
116

 
136

 
344

 
356

 
$
750

 
$
886

 
$
1,941

 
$
2,366

See accompanying notes.

4



Google Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In millions)
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2013
 
2012
 
2013
 
(unaudited)
Net income
$
2,176

 
$
2,970

 
$
7,851

 
$
9,544

Other comprehensive income (loss):
 
 
 
 
 
 
 
Change in foreign currency translation adjustment
220

 
261

 
(98
)
 
57

Available-for-sale investments:
 
 
 
 
 
 
 
Change in net unrealized gains (losses)
198

 
257

 
408

 
(402
)
Reclassification adjustment for net (gains) losses included in net income
(21
)
 
21

 
(169
)
 
(133
)
Net change (net of tax effect of $73, $31, $83, and $208)
177

 
278

 
239

 
(535
)
Cash flow hedges:
 
 
 
 
 
 
 
Change in net unrealized gains (losses)
(74
)
 
(28
)
 
65

 
97

Less: reclassification adjustment for net (gains) losses included in net income
(39
)
 
(14
)
 
(114
)
 
(58
)
Net change (net of tax effect of $67, $24, $29, and $23)
(113
)
 
(42
)
 
(49
)
 
39

Other comprehensive income (loss)
284

 
497

 
92

 
(439
)
Comprehensive income
$
2,460

 
$
3,467

 
$
7,943

 
$
9,105

See accompanying notes.

5


Google Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
 
Nine Months Ended
 
September 30,
 
2012
 
2013
 
(unaudited)
Operating activities
 
 
 
Net income
$
7,851

 
$
9,544

Adjustments:
 
 
 
Depreciation and amortization of property and equipment
1,358

 
2,024

Amortization of intangible and other assets
651

 
879

Stock-based compensation expense
1,976

 
2,441

Excess tax benefits from stock-based award activities
(113
)
 
(302
)
Deferred income taxes
23

 
125

Gain on divestiture of businesses
(188
)
 
(705
)
Other
(24
)
 
44

Changes in assets and liabilities, net of effects of acquisitions:
 
 
 
Accounts receivable
(228
)
 
(454
)
Income taxes, net
1,336

 
(79
)
Inventories
188

 
(46
)
Prepaid revenue share, expenses and other assets
(1,215
)
 
(149
)
Accounts payable
(274
)
 
285

Accrued expenses and other liabilities
484

 
(270
)
Accrued revenue share
(57
)
 
8

Deferred revenue
182

 
76

Net cash provided by operating activities
11,950

 
13,421

Investing activities
 
 
 
Purchases of property and equipment
(2,253
)
 
(5,103
)
Purchases of marketable securities
(24,246
)
 
(31,746
)
Maturities and sales of marketable securities
29,800

 
23,241

Investments in non-marketable equity investments
(246
)
 
(471
)
Cash collateral related to securities lending
(321
)
 
220

Investments in reverse repurchase agreements
195

 
600

Proceeds from divestiture of businesses
201

 
2,525

Acquisitions, net of cash acquired, and purchases of intangibles and other assets
(10,672
)
 
(1,328
)
Net cash used in investing activities
(7,542
)
 
(12,062
)
Financing activities
 
 
 
Net payments related to stock-based award activities
(189
)
 
(637
)
Excess tax benefits from stock-based award activities
113

 
302

Proceeds from issuance of debt, net of costs
12,125

 
8,350

Repayments of debt
(10,128
)
 
(8,904
)
Net cash provided by (used in) financing activities
1,921

 
(889
)
Effect of exchange rate changes on cash and cash equivalents
(52
)
 
(6
)
Net increase in cash and cash equivalents
6,277

 
464

Cash and cash equivalents at beginning of period
9,983

 
14,778

Cash and cash equivalents at end of period
$
16,260

 
$
15,242

 
 
 
 
Supplemental disclosures of cash flow information
 
 
 
Cash paid for taxes
$
1,684

 
$
1,304

Cash paid for interest
$
38

 
$
36

Non-cash investing and financing activities:
 
 
 
Receipt of Arris shares in connection with divestiture of Motorola Home
$
0

 
$
175

Fair value of stock-based awards assumed in connection with acquisition of Motorola
$
41

 
$
0

Property under capital lease
$
0

 
$
258

See accompanying notes.


6


Google Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Google Inc. and Summary of Significant Accounting Policies
We were incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. We generate revenues primarily by delivering relevant, cost-effective online advertising in our Google segment. To a lesser extent, we generate revenues primarily from sales of mobile devices in our Motorola Mobile segment.
In April 2013, we completed the sale of our Motorola Home segment to Arris Group, Inc. (Arris) and certain other persons. See Note 8 for further discussion of the sale of Motorola Home.
Basis of Consolidation
The consolidated financial statements include the accounts of Google Inc. and our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated.
Unaudited Interim Financial Information
The accompanying Consolidated Balance Sheet as of September 30, 2013, the Consolidated Statements of Income for the three and nine months ended September 30, 2012 and 2013, the Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2012 and 2013, and the Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2013 are unaudited. These unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (GAAP). In our opinion, the unaudited interim consolidated financial statements include all adjustments of a normal recurring nature necessary for the fair presentation of our financial position as of September 30, 2013, our results of operations for the three and nine months ended September 30, 2012 and 2013, and our cash flows for the nine months ended September 30, 2012 and 2013. The results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of the results to be expected for the year ending December 31, 2013.
These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 filed with the SEC on January 29, 2013.
Use of Estimates
The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable and sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, fair values of stock-based awards, inventory valuations, income taxes, and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.
In the second quarter of 2013, we revised the estimated useful lives of certain types of property and equipment which resulted in an additional depreciation expense of $48 million and $169 million during the three and nine months ended September 30, 2013.
Prior Period Reclassifications
Certain reclassifications of prior period amounts have been made to conform to the current period presentation.
Note 2. Net Income Per Share of Class A and Class B Common Stock
The following table sets forth the computation of basic and diluted net income per share of Class A and Class B common stock (in millions, except share amounts which are reflected in thousands and per share amounts):

7


 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2013
 
2012
 
2013
 
(unaudited)
 
Class A
 
Class B
 
Class A
 
Class B
 
Class A
 
Class B
 
Class A
 
Class B
Basic net income (loss) per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Numerator
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allocation of undistributed earnings - continuing operations
$
1,732

 
$
426

 
$
2,438

 
$
517

 
$
6,293

 
$
1,588

 
$
7,237

 
$
1,596

Allocation of undistributed earnings - discontinued operations
14

 
4

 
12

 
3

 
(24
)
 
(6
)
 
582

 
129

Total
$
1,746

 
$
430

 
$
2,450

 
$
520

 
$
6,269

 
$
1,582

 
$
7,819

 
$
1,725

Denominator
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of shares used in per share computation
263,086

 
64,699

 
275,237

 
58,379

 
260,666

 
65,786

 
272,150

 
60,033

Basic net income (loss) per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Continuing operations
$
6.59

 
$
6.59

 
$
8.86

 
$
8.86

 
$
24.14

 
$
24.14

 
$
26.59

 
$
26.59

Discontinued operations
0.05

 
0.05

 
0.04

 
0.04

 
(0.09
)
 
(0.09
)
 
2.14

 
2.14

Basic net income per share
$
6.64

 
$
6.64

 
$
8.90

 
$
8.90

 
$
24.05

 
$
24.05

 
$
28.73

 
$
28.73

Diluted net income (loss) per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Numerator
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allocation of undistributed earnings for basic computation - continuing operations
$
1,732

 
$
426

 
$
2,438

 
$
517

 
$
6,293

 
$
1,588

 
$
7,237

 
$
1,596

Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares
426

 
0

 
517

 
0

 
1,588

 
0

 
1,596

 
0

Reallocation of undistributed earnings to Class B shares
0

 
(7
)
 
0

 
(8
)
 
0

 
(23
)
 
0

 
(27
)
Allocation of undistributed earnings - continuing operations
$
2,158

 
$
419

 
$
2,955

 
$
509

 
$
7,881

 
$
1,565

 
$
8,833

 
$
1,569

Allocation of undistributed earnings for basic computation - discontinued operations
$
14

 
$
4

 
$
12

 
$
3

 
$
(24
)
 
$
(6
)
 
$
582

 
$
129

Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares
4

 
0

 
3

 
0

 
(6
)
 
0

 
129

 
0

Reallocation of undistributed earnings to Class B shares
0

 
0

 
0

 
0

 
0

 
0

 
0

 
(3
)
Allocation of undistributed earnings - discontinued operations
$
18

 
$
4

 
$
15

 
$
3

 
$
(30
)
 
$
(6
)
 
$
711

 
$
126

Denominator
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of shares used in basic computation
263,086

 
64,699

 
275,237

 
58,379

 
260,666

 
65,786

 
272,150

 
60,033

Weighted-average effect of dilutive securities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Add:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Conversion of Class B to Class A common shares outstanding
64,699

 
0

 
58,379

 
0

 
65,786

 
0

 
60,033

 
0

Employee stock options, including warrants issued under Transferable Stock Option program
3,015

 
36

 
2,607

 
1

 
2,943

 
39

 
2,800

 
5

Restricted stock units
2,514

 
0

 
3,012

 
0

 
2,019

 
0

 
3,095

 
0

Number of shares used in per share computation
333,314

 
64,735

 
339,235

 
58,380

 
331,414

 
65,825

 
338,078

 
60,038

Diluted net income (loss) per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Continuing operations
$
6.48

 
$
6.48

 
$
8.71

 
$
8.71

 
$
23.78

 
$
23.78

 
$
26.13

 
$
26.13

Discontinued operations
0.05

 
0.05

 
0.04

 
0.04

 
(0.09
)
 
(0.09
)
 
2.10

 
2.10

Diluted net income per share
$
6.53

 
$
6.53

 
$
8.75

 
$
8.75

 
$
23.69

 
$
23.69

 
$
28.23

 
$
28.23

The net income per share amounts are the same for Class A and Class B common stock because the holders of each class are legally entitled to equal per share distributions whether through dividends or in liquidation.

8




Note 3. Financial Instruments

Fair Value Measurements
We measure our cash equivalents, marketable securities, and foreign currency and interest rate derivative contracts at fair value on a recurring basis. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. A three-tier fair value hierarchy is established as a basis for considering such assumptions and for inputs used in the valuation methodologies in measuring fair value:
Level 1—Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2—Include other inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings.
Level 3—Unobservable inputs that are supported by little or no market activities.
The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
Based on the fair value hierarchy, we classify our cash equivalents and marketable securities within Level 1 or Level 2. This is because we value our cash equivalents and marketable securities using quoted market prices or alternative pricing sources and models utilizing market observable inputs. We classify our foreign currency and interest rate derivative contracts primarily within Level 2 as the valuation inputs are based on quoted prices and market observable data of similar instruments.

Cash, Cash Equivalents and Marketable Securities
 The following tables summarize our cash, cash equivalents and marketable securities by significant investment categories as of December 31, 2012 and September 30, 2013 (in millions):

9


 
 
As of December 31, 2012
 
 
Adjusted
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
Cash and
Cash
Equivalents
 
Marketable
Securities
Cash
 
$
8,066

 
$
0

 
$
0

 
$
8,066

 
$
8,066

 
$
0

Level 1:
 
 
 
 
 
 
 
 
 
 
 
 
Money market and other funds
 
5,221

 
0

 
0

 
5,221

 
5,221

 
0

U.S. government notes
 
10,853

 
77

 
(1
)
 
10,929

 
0

 
10,929

Marketable equity securities
 
12

 
88

 
0

 
100

 
0

 
100

 
 
16,086

 
165

 
(1
)
 
16,250

 
5,221

 
11,029

Level 2:
 
 
 
 
 
 
 
 
 
 
 
 
Time deposits
 
984

 
0

 
0

 
984

 
562

 
422

Money market and other funds (1)
 
929

 
0

 
0

 
929

 
929

 
0

U.S. government agencies
 
1,882

 
20

 
0

 
1,902

 
0

 
1,902

Foreign government bonds
 
1,996

 
81

 
(3
)
 
2,074

 
0

 
2,074

Municipal securities
 
2,249

 
23

 
(6
)
 
2,266

 
0

 
2,266

Corporate debt securities
 
7,200

 
414

 
(14
)
 
7,600

 
0

 
7,600

Agency residential mortgage-backed securities
 
7,039

 
136

 
(6
)
 
7,169

 
0

 
7,169

Asset-backed securities
 
847

 
1

 
0

 
848

 
0

 
848

 
 
23,126

 
675

 
(29
)
 
23,772

 
1,491

 
22,281

Total
 
$
47,278

 
$
840

 
$
(30
)
 
$
48,088

 
$
14,778

 
$
33,310

 
 
As of September 30, 2013
 
 
Adjusted
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
Cash and
Cash
Equivalents
 
Marketable
Securities
 
(unaudited)
Cash
 
$
7,822

 
$
0

 
$
0

 
$
7,822

 
$
7,822

 
$
0

Level 1:
 
 
 
 
 
 
 
 
 
 
 
 
Money market and other funds
 
3,940

 
0

 
0

 
3,940

 
3,940

 
0

U.S. government notes
 
13,567

 
38

 
(30
)
 
13,575

 
402

 
13,173

Marketable equity securities
 
241

 
173

 
0

 
414

 
0

 
414

 
 
17,748

 
211

 
(30
)
 
17,929

 
4,342

 
13,587

Level 2:
 
 
 
 
 
 
 
 
 
 
 
 
Time deposits
 
1,753

 
0

 
0

 
1,753

 
1,294

 
459

Money market and other funds(1)
 
1,784

 
0

 
0

 
1,784

 
1,784

 
0

U.S. government agencies
 
2,330

 
5

 
(3
)
 
2,332

 
0

 
2,332

Foreign government bonds
 
2,408

 
13

 
(49
)
 
2,372

 
0

 
2,372

Municipal securities
 
3,579

 
13

 
(48
)
 
3,544

 
0

 
3,544

Corporate debt securities
 
9,323

 
163

 
(140
)
 
9,346

 
0

 
9,346

Agency residential mortgage-backed securities
 
8,597

 
80

 
(152
)
 
8,525

 
0

 
8,525

Asset-backed securities
 
1,118

 
0

 
(2
)
 
1,116

 
0

 
1,116

 
 
30,892

 
274

 
(394
)
 
30,772

 
3,078

 
27,694

Total
 
$
56,462

 
$
485

 
$
(424
)
 
$
56,523

 
$
15,242

 
$
41,281


(1)
The balances at December 31, 2012 and September 30, 2013 were related to cash collateral received in connection with our securities lending program, which was invested in reverse repurchase agreements maturing within three months. See below for further discussion of this program.




10


During the second quarter of 2013, we received approximately $175 million in Arris' common stock (10.6 million shares) in connection with the sale of the Motorola Home segment (see details in Note 8). These shares are accounted for as available-for sale marketable equity securities.
We determine realized gains or losses on the sale of marketable securities on a specific identification method. We recognized gross realized gains of $82 million and $290 million for the three and nine months ended September 30, 2012 and $35 million and $295 million for the three and nine months ended September 30, 2013. We recognized gross realized losses of $46 million and $79 million for the three and nine months ended September 30, 2012 and $61 million and $117 million for the three and nine months ended September 30, 2013. We reflect these gains and losses as a component of interest and other income, net, in the accompanying Consolidated Statements of Income.
The following table summarizes the estimated fair value of our investments in marketable securities, excluding marketable equity securities, designated as available-for-sale and classified by the contractual maturity date of the securities (in millions):
 
As of
September 30,
2013
 
(unaudited)
Due in 1 year
$
4,809

Due in 1 year through 5 years
18,819

Due in 5 years through 10 years
8,375

Due after 10 years
8,864

Total
$
40,867

The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2012 and September 30, 2013, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions):
 
 
As of December 31, 2012
 
 
Less than 12 Months
 
12 Months or Greater
 
Total
 
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
U.S. government notes
 
$
842

 
$
(1
)
 
$
0

 
$
0

 
$
842

 
$
(1
)
Foreign government bonds
 
509

 
(2
)
 
12

 
(1
)
 
521

 
(3
)
Municipal securities
 
686

 
(6
)
 
9

 
0

 
695

 
(6
)
Corporate debt securities
 
820

 
(10
)
 
81

 
(4
)
 
901

 
(14
)
Agency residential mortgage-backed securities
 
1,300

 
(6
)
 
0

 
0

 
1,300

 
(6
)
Total
 
$
4,157

 
$
(25
)
 
$
102

 
$
(5
)
 
$
4,259

 
$
(30
)
 
 
As of September 30, 2013
 
 
Less than 12 Months
 
12 Months or Greater
 
Total
 
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
 
 
 
 
 
(unaudited)
 
 
 
 
U.S. government notes
 
$
4,329

 
$
(30
)
 
$
0

 
$
0

 
$
4,329

 
$
(30
)
U.S. government agencies
 
849

 
(3
)
 
0

 
0

 
849

 
(3
)
Foreign government bonds
 
1,563

 
(47
)
 
38

 
(2
)
 
1,601

 
(49
)
Municipal securities
 
1,845

 
(47
)
 
9

 
(1
)
 
1,854

 
(48
)
Corporate debt securities
 
4,667

 
(136
)
 
48

 
(4
)
 
4,715

 
(140
)
Agency residential mortgage-backed securities
 
4,974

 
(149
)
 
224

 
(3
)
 
5,198

 
(152
)
Asset-backed securities
 
734

 
(2
)
 
0

 
0

 
734

 
(2
)
Total
 
$
18,961

 
$
(414
)
 
$
319

 
$
(10
)
 
$
19,280

 
$
(424
)

11


We periodically review our marketable debt and equity securities for other-than-temporary impairment. We consider factors such as the duration, severity and the reason for the decline in value, the potential recovery period and our intent to sell. For marketable debt securities, we also consider whether (i) it is more likely than not that we will be required to sell the debt securities before recovery of their amortized cost basis, and (ii) the amortized cost basis cannot be recovered as a result of credit losses. During the three and nine months ended September 30, 2013, we did not recognize any other-than-temporary impairment loss.
Securities Lending Program
From time to time, we enter into securities lending agreements with financial institutions to enhance investment income. We loan selected securities which are collateralized in the form of cash or securities. Cash collateral is invested in reverse repurchase agreements which are collateralized in the form of securities.
We classify loaned securities as cash equivalents or marketable securities and record the cash collateral as an asset with a corresponding liability in the accompanying Consolidated Balance Sheets. We classify reverse repurchase agreements maturing within three months as cash equivalents and those longer than three months as receivable under reverse repurchase agreements in the accompanying Consolidated Balance Sheets. For security collateral received, we do not record an asset or liability except in the event of counterparty default.
Derivative Financial Instruments
We recognize derivative instruments as either assets or liabilities in the accompanying Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the accompanying Consolidated Statements of Income as interest and other income, net, as part of revenues, or as a component of accumulated other comprehensive income (AOCI) in the accompanying Consolidated Balance Sheets, as discussed below.
We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows and earnings will be adversely affected by foreign currency exchange rate fluctuations. We use certain interest rate derivative contracts to hedge interest rate exposures on our fixed income securities and our anticipated debt issuance. Our program is not used for trading or speculative purposes.
We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. To further reduce credit risk, we enter into collateral security arrangements under which the counterparty is required to provide collateral when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We can take possession of the collateral in the event of counterparty default. As of December 31, 2012 and September 30, 2013, we received cash collateral related to the derivative instruments under our collateral security arrangements of $43 million and $12 million.
Cash Flow Hedges
We use options designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. The notional principal of these contracts was approximately $9.5 billion and $7.0 billion as of December 31, 2012 and September 30, 2013. These foreign exchange contracts have maturities of 36 months or less.
In 2012, we entered into forward-starting interest rate swaps that effectively locked in an interest rate on our anticipated debt issuance of $1.0 billion in 2014. The total notional amount of these forward-starting interest swaps was $1.0 billion as of December 31, 2012 and September 30, 2013 with terms calling for us to receive interest at a variable rate and to pay interest at a fixed rate.
We initially report any gain or loss on the effective portion of a cash flow hedge as a component of AOCI and subsequently reclassify cumulative gains and losses to revenues or interest expense when the hedged transactions are recorded. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI would be reclassified to interest and other income, net. Further, we exclude the change in the time value of the options from our assessment of hedge effectiveness. We record the premium paid or time value of an option on the date of purchase as an asset. Thereafter, we recognize any change to this time value in interest and other income, net.
As of September 30, 2013, the effective portion of our cash flow hedges before tax effect was $73 million, of which $7 million is expected to be reclassified from AOCI into earnings within the next 12 months.


12


Fair Value Hedges
We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. Gains and losses on these contracts are recognized in interest and other income, net, along with the offsetting losses and gains of the related hedged items. We exclude changes in the time value for forward contracts from the assessment of hedge effectiveness. The notional principal of these contracts was $1.1 billion and $1.6 billion as of December 31, 2012 and September 30, 2013.
Other Derivatives
Other derivatives not designated as hedging instruments consist of forward and option contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts, as well as the related costs in interest and other income, net, along with the foreign currency gains and losses on monetary assets and liabilities. The notional principal of foreign exchange contracts outstanding was $6.6 billion and $6.1 billion at December 31, 2012 and September 30, 2013.
We also use exchange-traded interest rate futures contracts and “To Be Announced” (TBA) forward purchase commitments of mortgage-backed assets to hedge interest rate risks on certain fixed income securities. The TBA contracts meet the definition of derivative instruments in cases where physical delivery of the assets is not taken at the earliest available delivery date. Our interest rate futures and TBA contracts (together interest rate contracts) are not designated as hedging instruments. We recognize gains and losses on these contracts, as well as the related costs in interest and other income, net. The gains and losses are generally economically offset by unrealized gains and losses in the underlying available-for-sale securities, which are recorded as a component of AOCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from AOCI into interest and other income, net. The total notional amounts of interest rate contracts outstanding were $25 million at December 31, 2012 and $75 million at September 30, 2013.
The fair values of our outstanding derivative instruments were as follows (in millions):

 
 
 
 
As of December 31, 2012
  
 
Balance Sheet Location
 
Fair Value of
Derivatives
Designated as
Hedging Instruments
 
Fair Value of
Derivatives Not
Designated as
Hedging Instruments
 
Total Fair
Value
Derivative Assets:
 
 
 
 
 
 
 
 
Level 2:
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
Prepaid revenue share, expenses and other assets, current and non-current
 
$
164

 
$
13

 
$
177

Interest rate contracts
 
Prepaid revenue share, expenses and other assets, current and non-current
 
1

 
0

 
1

Total
 
 
 
$
165

 
$
13

 
$
178

Derivative Liabilities:
 
 
 
 
 
 
 
 
Level 2:
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
Accrued expenses and other current liabilities
 
$
3

 
$
4

 
$
7



13


 
 
 
 
As of September 30, 2013
  
 
Balance Sheet Location
 
Fair Value of
Derivatives
Designated as
Hedging Instruments
 
Fair Value of
Derivatives Not
Designated as
Hedging Instruments
 
Total Fair
Value
 
 
 
 
(unaudited)
Derivative Assets:
 
 
 
 
 
 
 
 
Level 2:
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
Prepaid revenue share, expenses and other assets, current and non-current
 
$
67

 
$
3

 
$
70

Interest rate contracts
 
Prepaid revenue share, expenses and other assets, current and non-current
 
68

 
0

 
68

Total
 
 
 
$
135

 
$
3

 
$
138

 
 
 
 
 
 
 
 
 
Derivative Liabilities:
 
 
 
 
 
 
 
 
Level 2:
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
Accrued expenses and other current liabilities
 
$
15

 
$
0

 
$
15

Total
 
 
 
$
15

 
$
0

 
$
15

The effect of derivative instruments in cash flow hedging relationships on income and other comprehensive income (OCI) is summarized below (in millions):
 
 
 
Gains (Losses) Recognized in OCI
on Derivatives Before Tax Effect (Effective Portion)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Derivatives in Cash Flow Hedging Relationship
 
2012
 
2013
 
2012
 
2013
 
 
(unaudited)
Foreign exchange contracts
 
$
(110
)
 
$
(43
)
 
$
110

 
$
87

Interest rate contracts
 
(8
)
 
(1
)
 
(8
)
 
67

Total
 
$
(118
)
 
$
(44
)
 
$
102

 
$
154

 
 
 
Gains Reclassified from AOCI into Income (Effective Portion)
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Derivatives in Cash Flow Hedging Relationship
 
Location
 
2012
 
2013
 
2012
 
2013
 
 
 
 
(unaudited)
Foreign exchange contracts
 
Revenues
 
$
62

 
$
22

 
$
180

 
$
92

 

14


 
 
Gains (Losses) Recognized in Income on Derivatives (Amount
Excluded from  Effectiveness Testing and Ineffective Portion) (1)
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Derivatives in Cash Flow Hedging Relationship
 
Location
 
2012
 
2013
 
2012
 
2013
 
 
 
 
(unaudited)
Foreign exchange contracts
 
Interest and
other income, net
 
$
(124
)
 
$
(135
)
 
$
(370
)
 
$
(224
)
 
(1) 
Gains (losses) related to the ineffective portion of the hedges were not material in all periods presented.
The effect of derivative instruments in fair value hedging relationships on income is summarized below (in millions):
 
 
 
Gains (Losses) Recognized in Income on Derivatives(2)
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Derivatives in Fair Value Hedging Relationship
 
Location
 
2012
 
2013
 
2012
 
2013
 
 
 
 
(unaudited)
Foreign exchange contracts
 
Interest and
other income, net
 
$
(38
)
 
$
(49
)
 
$
(22
)
 
$
13

Hedged item
 
Interest and
other income, net
 
36

 
46

 
15

 
(19
)
Total
 
 
 
$
(2
)
 
$
(3
)
 
$
(7
)
 
$
(6
)
 
(2) 
Losses related to the amount excluded from effectiveness testing of the hedges were $2 million and $7 million for the three and nine months ended September 30, 2012 and $3 million and $6 million for the three and nine months ended September 30, 2013.
The effect of derivative instruments not designated as hedging instruments on income is summarized below (in millions):
 
 
 
Gains (Losses) Recognized in Income on Derivatives
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Derivatives Not Designated As Hedging Instruments
 
Location
 
2012
 
2013
 
2012
 
2013
 
 
 
 
(unaudited)
Foreign exchange contracts
 
Interest and
other income, net
 
$
(82
)
 
$
(55
)
 
$
(107
)
 
$
102

Interest rate contracts
 
Interest and
other income, net
 
0

 
2

 
(5
)
 
2

Total
 
 
 
$
(82
)
 
$
(53
)
 
$
(112
)
 
$
104



Offsetting of Derivatives, Securities Lending and Reverse Repurchase Agreements

We present our derivatives, securities lending and reverse repurchase agreements at gross fair values in the Consolidated Balance Sheets. However, our master netting and other similar arrangements allow net settlements under certain conditions. As of December 31, 2012 and September 30, 2013, information related to these offsetting arrangements was as follows (in millions, unaudited):

15


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Offsetting of Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31, 2012
 
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset
 
 
Description
 
Gross Amounts of Recognized Assets
 
Gross Amounts Offset in the Consolidated Balance Sheets
 
Net Presented in the Consolidated Balance Sheets
 
Financial Instruments
 
 Cash Collateral Received
 
Non-Cash Collateral Received
 
Net Assets Exposed
Derivatives
 
$
178

 
$
0

 
$
178

 
$
(4
)
(1) 
$
(40
)
 
$
(12
)
 
$
122

Reverse repurchase agreements
 
1,629

 
0

 
1,629

(2) 
0

 
0

 
(1,629
)
 
0

Total
 
$
1,807

 
$
0

 
$
1,807

 
$
(4
)
 
$
(40
)
 
$
(1,641
)
 
$
122

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of September 30, 2013
 
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset
 
 
Description
 
Gross Amounts of Recognized Assets
 
Gross Amounts Offset in the Consolidated Balance Sheets
 
Net Presented in the Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral Received
 
Non-Cash Collateral Received
 
Net Assets Exposed
Derivatives
 
$
138

 
$
0

 
$
138

 
$
0

(1) 
$
(8
)
 
$
(31
)
 
$
99

Reverse repurchase agreements
 
1,884

 
0

 
1,884

(2) 
0

 
0

 
(1,884
)
 
0

Total
 
$
2,022

 
$
0

 
$
2,022

 
$
0

 
$
(8
)
 
$
(1,915
)
 
$
99

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

(1) The balances at December 31, 2012 and September 30, 2013 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements.

(2) The balances at December 31, 2012 and September 30, 2013 included $929 million and $1,784 million recorded in cash and cash equivalents, respectively, and $700 million and $100 million recorded in receivable under reverse repurchase agreements, respectively.



16


Offsetting of Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31, 2012
 
 
 
 
 
 
 
 
Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset
 
 
Description
 
Gross Amounts of Recognized Liabilities
 
Gross Amounts Offset in the Consolidated Balance Sheets
 
Net Presented in the Consolidated Balance Sheets
 
Financial Instruments
 
 Cash Collateral Pledged
 
Non-Cash Collateral Pledged
 
Net Liabilities
Derivatives
 
$
7

 
$
0

 
$
7

 
$
(4
)
(3) 
$
0

 
$
0