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. 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 measured at adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment categories as of December 31, 2011 and December 31, 2012 (in millions):


	As of December 31, 2011
	Adjusted Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Cash and Cash Equivalents		Marketable Securities
Cash	$	4,712	$	0	$	0		$	4,712	$	4,712	$	0
Level 1:
Money market and other funds		3,202		0		0			3,202		3,202		0
U.S. government notes		11,475		104		0			11,579		0		11,579
Marketable equity securities		228		79		0			307		0		307

		14,905		183		0			15,088		3,202		11,886
Level 2:
Time deposits		1,029		0		0			1,029		534		495
Money market and other funds⁽¹⁾		1,260		0		0			1,260		1,260		0
U.S. government agencies		6,486		15		0			6,501		275		6,226
Foreign government bonds		1,608		32		(11	)		1,629		0		1,629
Municipal securities		1,775		19		0			1,794		0		1,794
Corporate debt securities		6,023		187		(98	)		6,112		0		6,112
Agency residential mortgage-backed securities		6,359		147		(5	)		6,501		0		6,501

		24,540		400		(114	)		24,826		2,069		22,757

Total	$	44,157	$	583	$	(114	)	$	44,626	$	9,983	$	34,643


	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

⁽¹⁾	The balances at December 31, 2011 and December 31, 2012 were 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 on this program.

We determine realized gains or losses on the sale of marketable securities on a specific identification method. We recognized gross realized gains of $381 million and $383 million for the years ended December 31, 2011 and December 31, 2012. We recognized gross realized losses of $127 million and $101 million for the years ended December 31, 2011 and December 31, 2012. In 2011, we also recorded an other-than-temporary impairment charge of $88 million related to our investment in Clearwire Corporation. We reflect these gains and losses as a component of interest and other income, net, in our 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 December 31, 2012
Due in 1 year	$	4,708
Due in 1 year through 5 years		12,310
Due in 5 years through 10 years		7,296
Due after 10 years		8,896

Total	$	33,210

The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2011 and December 31, 2012, 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, 2011
	Less than 12 Months					12 Months or Greater					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Foreign government bonds	$	302	$	(11	)	$	6	$	0		$	308	$	(11	)
Corporate debt securities		2,160		(97	)		17		(1	)		2,177		(98	)
Agency residential mortgage-backed securities		716		(3	)		19		(2	)		735		(5	)

Total	$	3,178	$	(111	)	$	42	$	(3	)	$	3,220	$	(114	)


	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	)

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 secured by collateral in the form of cash or securities. Cash collateral is invested in reverse repurchase agreements. We classify loaned securities as cash equivalents or marketable securities on the accompanying Consolidated Balance Sheets. We record the cash collateral as an asset with a corresponding liability. We classify reverse repurchase agreements maturing within three months as cash equivalents and those longer than three months as receivable under reverse repurchase agreements on the accompanying Consolidated Balance Sheets. For lending agreements collateralized by securities, we do not record an asset or liability as we are not permitted to sell or repledge the associated collateral.

Derivative Financial Instruments

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 designated for trading or speculative purposes.

We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same company. To further reduce credit risk, we enter into collateral security arrangements that provide for collateral to be received when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We present our derivative assets and derivative liabilities at their gross fair values. At December 31, 2011 and December 31, 2012, we received cash collateral related to the derivative instruments under our collateral security arrangements of $113 million and $43 million, which are recorded as accrued expenses and other current liabilities in the accompanying Consolidated Balance Sheets.

We recognize derivative instruments as either assets or liabilities on 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 to accumulated other comprehensive income (AOCI) in the accompanying Consolidated Balance Sheets.

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 $6.5 billion and $9.5 billion as of December 31, 2011 and December 31, 2012. These foreign exchange contracts have maturities of 36 months or less.

During the second quarter of 2012, we began to hedge the variability of forecasted interest payments on an anticipated debt issuance using forward-starting interest swaps. The total notional amount of these forward-starting interest swaps was $1.0 billion as of December 31, 2012 with terms calling for us to receive interest at a variable rate and to pay interest at a fixed rate. These forward-starting interest swaps effectively fix the benchmark interest rate on an anticipated debt issuance of $1.0 billion in 2014, and they will be terminated upon issuance of the debt.

We initially report any gain or loss on the effective portion of a cash flow hedge as a component of AOCI and subsequently reclassify 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 December 31, 2012, the effective portion of our cash flow hedges before tax effect was $11 million, $10 million of which is expected to be reclassified from AOCI to revenues within the next 12 months.

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 and recognize them in interest and other income, net. The notional principal of these contracts was $1.0 billion and $1.1 billion as of December 31, 2011 and December 31, 2012.

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 gains and losses of the related hedged items. The notional principal of foreign exchange contracts outstanding was $3.7 billion and $6.6 billion at December 31, 2011 and December 31, 2012.

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 $100 million and $25 million at December 31, 2011 and December, 31, 2012.

The fair values of our outstanding derivative instruments were as follows (in millions):


		As of December 31, 2011
	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	$	333	$	4	$	337

Derivative Liabilities:
Level 2:
Foreign exchange contracts	Accrued expenses and other current liabilities	$	5	$	1	$	6


		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

The effect of derivative instruments in cash flow hedging relationships on income and other comprehensive income is summarized below (in millions):


	Gains Recognized in OCI on Derivatives Before Tax Effect (Effective Portion)
	Year Ended December 31,
Derivatives in Cash Flow Hedging Relationship	2010		2011		2012
Foreign exchange contracts	$	331	$	54	$	73
Interest rate contracts		0		0		1

Total	$	331	$	54	$	74


	Gains Reclassified from AOCI into Income (Effective Portion)
		Year Ended December 31,
Derivatives in Cash Flow Hedging Relationship	Location	2010		2011		2012
Foreign exchange contracts	Revenues	$	203	$	43	$	217


	Losses Recognized in Income on Derivatives (Amount Excluded from Effectiveness Testing and Ineffective Portion)⁽¹⁾
		Year Ended December 31,
Derivatives in Cash Flow Hedging Relationship	Location	2010			2011			2012
Foreign exchange contracts	Interest and other income, net	$	(320	)	$	(323	)	$	(447	)

⁽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⁾
		Year Ended December 31,
Derivatives in Fair Value Hedging Relationship	Location	2010			2011			2012
Foreign exchange contracts	Interest and other income, net	$	(35	)	$	(2	)	$	(31	)
Hedged item	Interest and other income, net		29			(12	)		23

Total		$	(6	)	$	(14	)	$	(8	)

⁽²⁾	Losses related to the amount excluded from effectiveness testing of the hedges were $6 million, $14 million, and $8 million for the years ended December 31, 2010, December 31, 2011, and December 31, 2012.

The effect of derivative instruments not designated as hedging instruments on income is summarized below (in millions):


	Gains (Losses) Recognized in Income on Derivatives
		Year Ended December 31,
Derivatives Not Designated As Hedging Instruments	Location	2010			2011			2012
Foreign exchange contracts	Interest and other income, net	$	(40	)	$	29		$	(67	)
Interest rate contracts	Interest and other income, net		0			(19	)		(6	)

Total		$	(40	)	$	10		$	(73	)